Definition and explanation
Revenue recognition principle of accounting (also known as realization concept) guides us when to recognize revenue in accounting records. According to this concept, the revenue is not recognized until it is earned and it is realized or at least realizable. Before exploring the concept of revenue recognition further through a few examples, we would briefly explain the two conditions (i.earned and ii.realized or realizable) imposed by the revenue recognition principle.
- The revenue is referred to have been earned when the entity sells goods or renders services and transfers the associated rewards and benefits to the buyer. At this point, the entity is generally entitled to the revenue because the value of goods and services provided can be objectively measured and the earning process is considered to have been completed. This condition focuses on the entity’s entitlement to the revenue. According to revenue recognition principle, the revenue is recognized when the entity is entitled to receive it, not at the time when it is actually received.
- The revenue is referred to have been realized when goods are sold or services are provided in exchange of cash or claims to cash (i.e., accounts receivable). The revenue is referred to be realizable when goods are sold or services are provided in exchange of an asset other then cash and such asset is readily convertible into cash or is exchangeable with other useful assets within reasonable time period and without incurring any additional cost. Revenue recognition principle requires that the revenue must be realized or realizable in order to recognize it in the accounting records.
To summarize the above discussion, we can say that the revenue is recognized when the entity is entitled to it (i.e., earned) provided that it is recoverable (i.e., realized or realizable), not at the time when it is received in cash. You may have noticed that the revenue recognition principle has a close relation with accrual concept of accounting which states that the revenue is recorded in the accounting period in which it is earned not in the period in which it is received in cash.
Where a company receives cash in advance for which goods or services are to be provided at a future time, it initially debits cash and credits unearned revenue (also known as prepaid revenue). Unearned revenue is a liability that is subsequently converted into earned revenue when the goods or services are provided to customers. It is done by debiting unearned revenue (or prepaid revenue) and crediting revenue.
A situation where company provides goods and services for which the cash is to be received at a future date, the revenue is recorded immediately without waiting for the time when the cash will be collected. It is recorded by debiting accounts receivable and crediting revenue.
- The Gibson Guitar Company places an order for a certain type of wood to Eastern Wood Company on January 25, 2015. The Eastern company ships the wood to Gibson company on February 5 , 2015. On the same date, the Gibson company intimates Eastern company that it has received the wood. The Gibson company makes the full payment of this order on February 20, 2015.
According to revenue recognition principle, Eastern company should record the revenue on February 5, 2015 when the wood is received by the Gibson not at the time of the placement of order or the time when cash is received.
- On December 25, 2015, the John Marketing Consultants receives $1,500 cash from SD corporation. This is an advance receipt of cash for which the consultancy service is to be provided in the month of January, 2016. On January 05, 2016, the relevant consultancy services are provided by John Marketing consultants to SD corporation.
According to revenue recognition principle, the John Marketing Consultants should recognize the revenue on January 05, 2016, not on December 25, 2015 when the cash is received SD from corporation.