Revenue recognition principle

Definition and explanation

The revenue recognition principle of accounting (also known as the realization concept) guides us when to recognize revenue in accounting records. According to this concept, revenue should not be recognized by an entity until it is (i) earned and (ii) realized or realizable. Before exploring the concept further through examples, we would briefly explain these two conditions (i.e., earned and realized or realizable) imposed by the revenue recognition principle.

(i). When revenue is referred to as earned?

This condition focuses on the entity’s entitlement to the revenue. According to the revenue recognition principle, revenue can be recognized when it is earned and the entity is entitled to receive it.

In a sales transaction, the revenue is referred to as earned when the seller satisfies its performance obligation by delivering the related goods or services to the buyer, along with all benefits and rights according to the terms of sale. At this point, the entity is generally entitled to receive the revenue because the value of goods and services sold to the buyer can be objectively measured and the earning process is completed.

(ii). When revenue is referred to as realized or realizable?

The revenue recognition principle requires that the revenue must be realized or realizable in order to be recognized in accounting records.

The revenue is referred to as “realized” when goods are sold or services are provided in exchange for cash or claims to cash (i.e., accounts receivable). It is referred to as “realizable” when goods or services are provided in exchange for a noncash asset that is readily convertible into cash without incurring any additional costs.

To summarize the above discussion, we can say that the revenue is recognized when the entity is entitled to receive it (i.e., earned) as well as it is recoverable (i.e., realized or realizable), not necessarily at the time when it is received in cash. You may have noticed that this principle has a close relation with the accrual concept of accounting, which states that the revenue is recorded in the accounting period in which it is earned, not 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 date, it initially debits cash and credits unearned revenue (also known as prepaid revenue). Unearned revenue is a liability that is subsequently converted to earned revenue when the related goods or services are provided to customers. It is done by debiting unearned revenue (or prepaid revenue) and crediting revenue.

In a situation where the 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.

Examples

1. Gibson Guitar Company places an order for a certain type of wood with Eastern Wood Company on January 25, 2015. Eastern ships the wood to Gibson on February 5, 2015. On the same date, Gibson intimates Eastern that it has received the wood. Gibson makes the full payment to Eastern for this order on February 20, 2015. According to the revenue recognition principle, Eastern should record the revenue on February 5, 2015, when the wood is received by Gibson, not at the time of the placement of the order or the time when cash is received.
2. On December 25, 2024, John Marketing Consultants receives $1,500 cash from SD Corporation. This is an advance receipt of cash for which the consultancy services are to be provided on January 8, 2025. On January 8, 2025, the relevant consultancy services are provided by John Marketing Consultants to SD Corporation. According to the revenue recognition principle, John Marketing Consultants should recognize the revenue on January 8, 2025, not on December 25, 2024, when the cash is received from SD Corporation.