The Revenue Recognition Principle: Definition & Examples

Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

A business earns its money by selling its goods and services, and it must decide when to record its earnings. In this lesson, you will learn about the revenue recognition principle.

What Is the Revenue Recognition Principle?

Let's meet Cathy, a lawyer, who owns a law office. Cathy recently met with her accountant who spoke with her about the rules for revenue recognition. Cathy still has some questions about what it is and how it applies to her business. Let's see if we can help Cathy with this problem.

Revenue is the amount of money that a company earns from selling its goods and services. In Cathy's business, revenue would be the amount she earns from providing legal services to her clients. In a merchandising or manufacturing business, revenue would be the amount of money earned by selling products to its customers.

Generally accepted accounting principles (GAAP) are rules developed by the accounting profession that help companies determine when they should record business events and transactions. One of these principles, the revenue recognition principle provides guidance about:

  • When a company should record revenue
  • The amount of revenue to record

According to this principle, companies should record revenue when it is earned. In most cases, this is when a company sells a product or completes its services. For Cathy's law firm, she would recognize revenue when she completes legal services for a client. A company would base the amount of revenue to record on the cash value of products or services provided to the customer. Cathy would base the amount of revenue to record on the value of the services her firm provided to her clients. For example, if Cathy completed services valued at $600 to a client in October, then she would record $600 of revenue in the month of October.

Financial statements are prepared using the accrual basis of accounting which states that a business should record a transaction or business event as it occurs, not when it receives cash. If Cathy waited until her clients paid her to record revenue, she may never record it. The reality is that some people never pay their bills and if Cathy waited until she received payment, there may be some revenue that she would never record.

Let's assume that Cathy completed legal work for a client on May 15th. She billed the client and the client paid her on June 7th. Since Cathy completed the work in May, she earned the revenue and can record it in May. She does not have to wait until she receives payment in June to record the revenue earned by her business.

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