When a company makes revenues from its operations, it must be recorded in the general ledger and then reported on the income statement every reporting period. According to generally accepted accounting principles (GAAP), there are two criteria the company must meet before it can record revenue on its books.
The first criterion must be a critical event that triggered the transaction process. The second criterion is the amount to be collected from that transaction must be measurable within a certain degree of reliability. Put more simply, a company can recognize revenue from a transaction when the buyer of the company's goods or services agrees to a making purchase, along with the amount it is going to pay.
Examples of Revenue Recognition
For example, a retail store will record revenue when a customer pays for a new pair of jeans. The critical event occurs when the store employee enters the merchandise through the till and rings up a measurable amount – namely, the price of the goods. The revenue recognition process for the store is complete when the customer pays for the merchandise. If the customer happens to return any merchandise, there will be another transaction on the store's books that will note the exchange and reduce its revenues accordingly.
The above is a simple example of revenue recording. But of course more complex arrangements exist.
Say, for example, a service contract is awarded to an engineering firm by a city authority to build a major highway over five years. Depending on the service contract and how the municipality pays for the new highway, the engineering firm could record revenues in a few different ways, though the end result would still be the same.
If the municipality pays for the entire project up front, then the engineering firm would record all of the revenue from this service contract at that time. However, if the municipality pays for the highway over the life of the project (a more probable scenario), the company would record the revenues as they are collected from the municipality. The critical event would be the signing of the contract, and the measurable transaction would be when the engineering firm invoices the municipality for services rendered. The invoice will most likely be different from the estimate done earlier due to the unpredictability of operating expenses.
Good Revenue Recognition Practices
It's worth noting that the revenue recognition principle stipulates that revenues are recognized when realized and earned, not necessarily when received. ("Realizable" means that goods and/or services have been received, but payment for the product/service is expected later). Often revenues are earned and received simultaneously, as in the retail store example. The engineering firm example demonstrates how there might be a delay between the two.
According to generally accepted accounting principles, 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 pay the bill and the firm doesn't receive the check until 2019. But exceptions can be made, depending on the industry. Regulators know how tempting it is for companies to push the limits on what qualifies as revenue, especially when not all revenue is collected when the work is done. As a result, analysts like to know that revenue recognition policies for a company, whatever they are, are relatively standard for the industry.