Revenue Recognition:

Revenue Recognition principle is one of the important principles of Accrual Accounting.

According to this principle, revenue must be recognized when
(1) They are realized or realizable and
(2) They are earned
Revenue is realized when products are exchanged for cash or claims to cash (Receivable).
Revenue is realizable when related assets received are readily convertible to cash or claims to
cash.
Revenue is earned when the products are delivered or services are performed.
Recognizing the revenue means recording the amount as revenue in the financial statements.
Realization is the process of converting non-cash resources into cash.
In the Revenue Recognition principle, it does not matter when cash is received. (In Cash Basis
Accounting, revenue is recognized when cash is received no matter when goods or services are
sold).
For revenue to be recognized, both the above conditions must be met. In other words for
revenue to be recognized, final delivery must be completed (of goods or services) and there has
to be a payment assurance.
Let us have a look at the timing of Revenue Recognition
1) For sale of finished goods (Inventory Items), revenue is recognized at the date of sale (some
interpret this as the date of shipping or the date of delivery)
2) For sale of services (e.g. support services), revenue is recognized when the services are
performed (delivered)
3) For sale of Asset Items (other than inventory items like finished goods), revenue is
recognized at the point of sale (i.e. when the customer is invoiced)
4) For revenue from other activities like rent for using companys Fixed Assets, revenue is
recognized as time passes or as assets are used.

Examples:
1) If a company invoices its customer for 100 units of item A, and ships (delivers) only 25 units,
the company cannot recognize revenue for entire 100 items. It can only recognize revenue
equivalent to the number of units delivered (Revenue is earned only when the products are
delivered). Similarly, lets say you pay $120 in advance to company ABC for magazine
subscription for one full year. The fact that company ABC received money for one full year
does not mean that they can record the entire amount as Revenue. In-fact the amount received
in advance is a Liability to the company because they have to deliver magazines to their
customer every month and if they fail to do so, they are liable to refund the amount received in
advance. In this scenario, the company will recognize 1/12th of the entire amount every month
as earned revenue after they deliver the magazine.

2) Company ZXC signs a 3 year support contract with its client for a total amount of 3 million.
This amount cannot be recorded as revenue unless the Company provides the support services
to the client. Assuming the company is following a monthly calendar accounting period, the
company will recognize 1/36th of the entire support contract deal amount every month.
(Revenue is recognized when services are performed)
There are few exceptions to the timing of revenue recognition for sale of inventory items. Under
normal scenario, revenue is recognizes at the point of sale, however if there are return policies,
and if the company cannot reasonably estimate the amount of future returns, the revenue
should be recognized only after the expiration of the return policy period.

Revenue Recognition Accounting:

If revenue is not recognized immediately, what is the accounting entry for the Sales Invoice?
Lets have a look
Lets say, you invoice the Customer in Advance for the annual support contract of $12000.
Since, you are invoicing the customer in Advance, you debit your Receivables. But then if you
are not crediting the revenue right away, where do you account for the credit side of the
accounting entry? You credit, what is called as Deferred Revenue (or Unearned Revenue).
Deferred Revenue is actually a liability for the company. (The company is liable to provide the
goods or services for which cash is received or will be received in advance). As and when the
goods or services are delivered, the Deferred Revenue is reduced (debited) and revenue is
recognized.
Accounting when the Invoice is created in Jan
Date
1-Jan

Accounting Class
Receivables

1-Jan

Deferred
Revenue

Debit
12000

Credit

Comments
The entire receivables is
recognized in advance.
How this receivable is
collected will depend on
the payment terms of the
Invoice

12000

End of Jan, Revenue is recognized for 1/12th of the entire amount, because the company has
provided one months service to its client. To that effect, Deferred Revenue will be reduced and
revenue will be recognized
Date
31-Jan
31-Jan

Accounting
Class
Deferred
Revenue
Earned Revenue

Debit

Credit

1000

End of Feb, another months revenue is recognized

1000

Comments
Deferred Revenue
reduced
Earned Revenue amount
for one month

Date
28-Feb
28-Feb

Accounting
Class
Deferred
Revenue
Earned Revenue

Debit

Credit

1000
1000

Comments
Deferred Revenue
reduced
Earned Revenue amount
for one month

The company will have similar accounting entry each month till Dec. At the end of Dec, the
Deferred Revenue will be Zero and the entire amount will be reported as Revenue earned.