The revenue recognition principle is one of the basic principles of accrual accounting. It states that a business should record revenue in the period in which it is earned, meaning when it delivers the goods or services it has promised to a customer, and in the amount it expects to be entitled to, regardless of when the customer pays. Cash received before delivery is a liability; cash still to come after delivery is a receivable.
Together with the matching principle, which ties expenses to the revenues they help produce, the revenue recognition principle determines when profit appears in the financial statements. This entry explains the principle itself and how it is applied in simple cases; the detailed five-step model now used under US GAAP and IFRS is covered under revenue recognition.
From earned and realized to transfer of control
For decades, US accounting expressed the principle with two tests: revenue was recognized when it was realized or realizable, meaning exchanged for cash or a claim to cash, and earned, meaning the business had substantially done what it needed to do. Industry-specific rules grew up around these tests, producing more than 100 pieces of US guidance that sometimes treated similar transactions differently.
In 2014 the FASB and the IASB issued a joint standard, ASC 606 in the United States and IFRS 15 internationally, effective for public companies from 2018. Its core principle is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration it expects to receive. The emphasis shifted from risks and rewards to the transfer of control: revenue is recognized when, or as, the customer obtains control of the good or service.
Applying the principle
- Sale of goods: a retailer recognizes revenue at the point of sale, when the customer takes the goods. A manufacturer shipping on credit recognizes revenue when control passes, often at shipment or delivery depending on the contract terms.
- Services over time: a consultancy with a six-month contract recognizes revenue progressively as the work is performed, for example by hours worked or milestones reached.
- Advance payments: a magazine publisher that collects a year's subscription up front records deferred revenue and recognizes it as each issue is delivered.
- Work done but not yet billed: a business records accrued revenue for services already provided at the period end.
Worked example
On 1 December a software firm signs a 12-month support contract for $24,000 and receives the full amount in cash. Its year ends on 31 December. On receipt, it debits cash $24,000 and credits deferred revenue $24,000, because it has not yet provided the service. On 31 December, one month of support has been delivered, so an adjusting entry debits deferred revenue $2,000 and credits service revenue $2,000. The income statement for the year shows $2,000 of revenue, and the balance sheet shows a $22,000 liability for the support still owed.
Under the cash basis of accounting, by contrast, all $24,000 would have been income in December, overstating that year's performance and understating the next.
Why the principle matters
Revenue is usually the largest number in the income statement and a key driver of share prices and executive bonuses, so recognizing it too early is one of the most common forms of financial misstatement. Examples include booking sales before goods are shipped, recording revenue on goods shipped to distributors who can return them freely, and recognizing a whole multi-year contract at signing. The Securities and Exchange Commission has brought many enforcement cases over improper revenue recognition, and auditors treat revenue as a presumed fraud risk under auditing standards. Consistent application of the principle supports comparability between periods and between companies, which is why disclosure of revenue accounting policies is required.