I. What is Revenue Recognition?

The Matching Principle
The matching principle of GAAP dictates that revenues must be matched with expenses. Thus, income and expenses are reported when they are earned and incurred, even if no cash transaction has been recorded.

For example, say a company made a sale for $30,000 within an accounting period but has not received payment. Even though the company was not paid, the sale is recorded as revenue. This revenue has to be matched with the expenses that the company incurred in the accounting period to generate that revenue (revenues and expanses must match).

If revenues were not matched with their related expenses, companies would produce financial statements that provide little information to the readers and themselves. (This is a fundamental principle of accrual-basis accounting)

Revenue-Recognition Principles
SFAS 5 specifies that two conditions must be met for revenue recognition to take place:

  1. Completion of the Earnings Process
    This means the company has provided all or virtually all of the goods and services for which it is to be paid. Furthermore, it means the company can measure the total expected cost of providing the goods and services, and the company must have no significant remaining obligations to its customers. Both must be true for this condition to be met.
  2. Assurance of Payment
    There must be a quantification of the cash or assets that will be received for realized goods and services. Furthermore, the company must be able to accurately estimate the reliability of payment. Both must be true for this requirement to be met.

Gross and Net Reporting of Revenue
Under gross revenue reporting, sales and the cost of goods sold are reported separately. With net revenue reporting only the net revenue, calculated by subtracting cost of goods sold from gross sales, is reported. Since the only the net revenue is reported, revenues will be less than under gross revenue reporting.

Under U.S. GAAP, a firm using gross revenue reporting must be the primary party to any contract, take on both inventory and credit risk, be able to choose its suppliers, and have the ability to set price.

When analyzing the financial statements analysts should be aware of how aggressive or conservative a firm's revenue recognition policies are. A firm's that has a very aggressive revenue recognition policy runs the risk of over stating its revenues and its earnings performance. Analysts should also be aware of any assumptions or judgments that are made in reporting revenues



Revenue Recognition Methods and Implications

Related Articles
  1. Managing Wealth

    Revenue Analyst: Career Path & Qualifications

    Learn more about the duties of a revenue analyst and the qualifications needed for the position, along with the career path for these professionals.
  2. Investing

    Financial Statements: Revenue

    By David Harper (Contact David)Revenue recognition refers to a set of accounting rules that governs how a company accounts for its sales. Many corporate accounting scandals have started with ...
  3. Investing

    What does Deferred Revenue Mean?

    Deferred revenue is advanced payments received by a company for products or services that it has not yet rendered or shipped. Another term for deferred revenue is unearned revenue. Whereas normal ...
  4. Investing

    What's Marginal Revenue?

    In microeconomics, marginal revenue is the additional revenue generated by increasing sales revenue by one unit. Another way of saying this is that the marginal revenue is the revenue generated ...
  5. Investing

    S&P 500 Index: A Revenue Case Study

    Discover the breakdown of aggregate total revenue of S&P 500 companies, including how much revenue is earned by country, industry and geographic location.
  6. Investing

    Fundamental Analysis: The Income Statement

    By Ben McClureThe income statement is basically the first financial statement you will come across in an annual report or quarterly Securities And Exchange Commission (SEC) filing. It also contains ...
  7. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  8. Investing

    What Is The Difference Between Revenue And Profit?

    Think of revenue as the top line of a company’s income statement. Profit is the infamous bottom line.
  9. Markets

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  10. Trading

    Stock Analysis Basics: How To Forecast Revenue and Growth

    Forecasted revenue and growth projections are important components of security analysis, leading to a stock’s future worth.
Trading Center