We've created this Basic Accounting Terms series to help you understand the fundamentals of accounting. Whether you handle the accounting yourself or have delegated it to an in-house or outsourced accountant, you'll find these posts useful as you review the financial health of your company with your accountant.
Money is constantly flowing in and out of your business. How do you know when you should recognize or account for revenue? Is it during production? When you receive any form of payment? What if your clients make installments? When do you start recognizing and recording the incoming money as revenue?
How about expenses? Is rent considered an expense only at the time of your monthly payment, or do you calculate this expense annually?
Recognizing revenue and expenses is a timing strategy that takes some thought and effort. Here's a few things to keep in mind as you work with your accountant:
Revenue Recognition Principle
So when do you recognize revenue in your reports, statements and forecasts? Let's start with defining the revenue recognition principle, and then we'll pick it apart:
Revenue Recognition Principle:
"Revenue recognition principle tells that revenue is to be recognized only when the rewards and benefits associated with the items sold or service provided is transferred, where the amount can be estimated reliably and when the amount is recoverable." -Accounting Explained
The textbook definition of the revenue recognition principle is:
Revenue recognition generally occurs (1) when realized or realizable and (2) when earned.
What? Ya. A little confusing. Let's break these definitions down:
When a company exchanges products, merchandise, or other assets for cash or claims to cash. For example:
- A monthly online academic journal receives 2,000 subscriptions of $180 to be paid at the beginning of the year. Each month it recognizes revenue worth $30,000 [($180 ÷ 12) × 2,000].
A company can consider revenues as earned when they have markedly accomplished what they have to do to be entitled to the benefits of the revenues.
Objective Test: Sales
Sales provide a verifiable measure of revenue--the sales price. If you attempt to recognize revenue before an actual sale occurs, you open the door to wide interpretations. Sales provide an objective and uniform test for revenue recognition.
"Companies recognize expenses not when they pay wages or make a product, but when the work (service) or the product actually contributes to revenue. Thus, companies tie expense recognition to revenue recognition. That is, by matching efforts (expenses) with accomplishment (revenues), the expense recognition principle is implemented in accordance with the definition of expense (outflows or other using up of assets or incurring of liabilities)." - Intermediate Accounting, 13th Edition
"Let the expense follow the revenue."
Why You Need to Know About Revenue and Expense Recognition:
"Often, a business will spend cash on producing their goods before it is sold or will receive cash for good sit has not yet delivered. Without the matching principle and the recognition rules, a business would be forced to record revenues and expenses when it received or paid cash. This could distort a business's income statement and make it look like they were doing much better or much worse than is actually the case. By tying revenues and expenses to the completion of sales and other money generating tasks, the income statement will better reflect what happened in terms of what revenue and expense generating activities during the accounting period." -Boundless
You want your reports and statements to be as accurate and as transparent as possible. Making sure you've recognized revenue and expenses at the right times will help you grow your business as you look for investors and satisfy shareholders.