Revenue Recognition Principle
The financial accounting term Revenue Recognition Principle refers to a standard condition under which revenues are recorded in a company’s financial statements. According to the Revenue Recognition Principle, revenue is recorded when it is realized or realizable and earned.
The Revenue Recognition Principle, along with the Matching Principle, is an important guideline used in accrual accounting; which means revenue can be recognized before it is received. This principle states revenue exists when two criteria are met:
- Realized / Realizable: products, merchandise or services are exchanged for cash or claims to cash (realized) or when an asset received is readily converted into cash (realizable).
- Earned: occurs when the business has substantially accomplished all that it must do to be entitled to the revenue. For example, a product is delivered or a service is rendered.
From a practical standpoint, businesses must use what is considered an objective test before indicating revenue has been recognized.
Generally, there are three categories of exceptions to the Revenue Recognition Principle:
- Revenues not Recognized at Sale: includes sales under buyback agreements (the company agrees to buy back merchandise under certain conditions), and returns (typically an estimate of the anticipated returned merchandise).
- Revenues Recognized Before Sale: includes long term contracts (which allow companies to bill the purchaser at pre-determined intervals), and the percentage of completion approach (which allows revenue to be recognized based on the percentage of the work that has been completed), or at the completion of a production cycle (typically used in mining or agriculture, allows for revenues to be recorded when an active market for the products exist and the selling price is reasonably known.)
- Revenues Recognized After Sale: if the eventual collection of accounts receivable has a high degree of uncertainty, the business must defer recognizing a portion of revenue it believes it will not be collecting in the future.