What is Revenue Recognition? - Principles, Process & Examples

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  • 1:11 Revenue Recognition Criteria
  • 3:37 Exceptions
  • 5:12 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

Did you know that when it comes to reporting revenue in the accounting records of a company, there is a certain time that it needs to be done? In this lesson, we are going to discuss the timing of revenue reporting and the Revenue Recognition Concept.

Revenue Recognition

Have you ever been pulled over by the police? I experienced that for the first time the other day. I couldn't understand why. I knew I wasn't speeding or driving erratically, so why in the world was this policeman pulling me over?

Well, it seems that I had a brake light out. Thankfully, I didn't get a ticket for that, but I could have. Unknowingly, I was breaking the law. Well, that made me start to think about laws in general. They're everywhere, including the world of accounting. Where the traffic laws are enforced by law enforcement, the laws of accounting are paroled by the Financial Accounting Standards Board. Part of the governance of the FASB falls to the Generally Accepted Accounting Principles, or GAAP, for short.

GAAP is the set of standards that enforces how accounting information is recorded and reported in the financial statements of a company. One of the concepts that's included in GAAP is revenue recognition. The textbook definition of revenue recognition is that it's the principle that states that revenue is recorded when it is realized or realizable and earned, not necessarily when it is received.

Recognition Criteria

So, let's break down the definition of revenue recognition to learn a little more about it. The definition states that revenue is recorded when it is realized. Realized means that products or services have been exchanged for cash. It also says that revenue can be realizable and still be recognized. Realizable means that products or services have been exchanged, but payment was not received and is expected to be received at a later date. The final component of the definition says that revenue must be earned. Earned simply means that services have been performed or goods have been exchanged.

Beyond that, there are a few more criteria that have to be checked off the list before revenue can be recognized and recorded. For starters, the manner in which revenue is generated must be considered complete or almost complete to count the revenue in the associated accounting period. Second, there must be a reasonable sense of assurance that the revenue earned is actually going to be received.

The third criterion in regards to revenue recognition is in conjunction with another GAAP principle called the matching principle. This concept states that the costs that are associated with generating revenue must be reported in the same time period as the revenue. Let's look at an example.

Bob builds fences. On the last day of June, he has almost finished constructing a nice privacy fence for Joe. The only thing that he has left to do is to install a gate. The gate is scheduled to arrive from the supplier the next day. Bob gives Joe the invoice for the cost of constructing the fence and promises to install the gate as soon as it comes in. Joe won't be paying Bob until the next day, when the job is 100% complete. Since it's the end of the accounting period and payment will not be received until the first day of the new accounting period, does Bob claim the revenue in this period or in the next?

Bob counts the revenue in the current accounting period, even though the payment has not been received yet. Why? Because the situation meets all criteria needed for revenue to be recognized and recorded. He has almost 100% completed the job, he's confident that payment will be received, the revenue is earned and realizable. It also meets the standard set by the matching principle, since the expenses that Bob incurred to erect the fence occurred in this accounting period, even though pay won't be received until the next period.

Exceptions to the Rule

As with anything, there are always exceptions to the rule. Revenue recognition is no different. There are three major exceptions to the revenue recognition principle.

To start, revenue can be recognized for projects that are expected to take a long time to finish, but payment is received at different stages of completion. A good example of this would be large construction projects. Most companies that enter into contracts to build large buildings that are going to take more than a few months to erect make sure that their contract tells specific points in time where revenue will be received. It could be set as receiving payment once a month, at different percentages of completion, or whatever the company decides. When payment is received, it is recognized and recorded.

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