Revenues earned from a company's operations must be recorded in the general ledger, then reported on an income statement every reporting period.
According to generally accepted accounting principles (GAAP), the following two criteria must be satisfied before the company can record revenue on its books:
- A critical event must trigger the transaction process.
- The money resulting from the transaction must be measurable within a certain degree of reliability. Simply put: the buyer of a company's goods must remit funds that match the stated price tag for said items.
- According to generally accepted accounting principles, for a company to record revenue on its books, there must be a critical event to signal a transaction, such as the sale of merchandise, or a contracted project, and there must be payment for the product or service that matches the stated price or agreed-upon fee.
- Revenues are recognized when earned, not necessarily when received.
- Revenues are often earned and received in a simultaneous transaction, such as the case when a customer makes a retail in-store purchase.
Examples of Revenue Recognition
Consider the scenario where a clothing retailer records revenue after a customer pays for a new pair of jeans. The critical event occurs when the cashier scans the bar code and rings up the merchandise for a measurable amount, which is the value stated on the price tag. The revenue recognition process is complete after the customer pays for the merchandise. If a customer returns any items of merchandise, the store separately records such transaction on its books, reducing overall revenues accordingly.
More complicated scenarios may occur. For example, suppose a city's transit authority contracts an engineering firm to construct a major highway. Assume this a vast and complex undertaking that's expected to take five years to complete. Depending on the agreed-upon payment schedule, the engineering firm may record revenues in various ways, although the end total would be the same.
For example, if the municipality pays for the entire project upfront, the engineering firm would record all of the revenue from this service contract at that time. But in the more-likely scenario where the municipality doles out installments over the life of the project, the engineering firm would record the revenues on a periodic basis, as monies are collected. In this example, the critical event is the signing of the contract, and the measurable transactions are the occasions when the engineering firm bills the municipality for services rendered.
Revenue Recognition Practices
GAAP stipulates that revenues are recognized when realized and earned, not necessarily when received. But revenues are often earned and received in a simultaneous transaction, as in the aforementioned retail store example. But the engineering firm example illustrates how there can be delays between the realization of earnings and the receipt of payment.
When to Record Revenue
According to GAAP, if the engineering firm bills for work done in 2018, the revenue for that work should be recognized in 2018—even if the city doesn't cut the check until 2019. But exceptions can be made in certain industries.