Revenue Recognition

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What is 'Revenue Recognition'

Revenue recognition is an accounting principle under generally accepted accounting principles (GAAP) that determines the specific conditions under which revenue is recognized or accounted for. Generally, revenue is recognized only when a specific critical event has occurred and the amount of revenue is measurable. However, there are several situations in which exceptions may apply.

BREAKING DOWN 'Revenue Recognition'

Revenue is at the heart of business performance. Everything hinges on the sale. As such, 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 being done. Lawyers tend to bill clients in billable hours and present the bill after the case is completed. Construction managers often bill clients on a percentage-of-completion method. As a result, analysts like to know that revenue recognition policies for a company are relatively standard for the industry. This also helps to ensure an apples-to-apples comparison is being made between metrics using line items from the income statement.

Revenue Recognition Examples

If you pay for a candy bar with cash, it is considered a sale. If you pay for the candy bar with a piece of Monopoly money, it is not considered a sale. So, for example, assume Sue the store owner must report sales to her investors and knows that revenue is not the same as cash on paper. Sue is desperate to look good on paper, so she takes the Monopoly money and recognizes it as revenue. Investors think the company has positive earnings, but the revenues aren't real. Thankfully, investors are protected against such a scenario for many reasons, one of which is because there are certain rules about recognizing revenue to prevent managers like Sue from recording a fake sale.

Revenue recognition states that revenue should not be recorded until it is earned. However, not all sales are made in cash. The speed with which credit sales become cash is also a critical component of revenue recognition.

The classic case of misguided revenue recognition is a furniture company that is having a bad year. As a promotional gesture, the manager extends credit terms with no money down. The furniture company sells out of furniture and recognizes sales as revenue on the income statement, but the manager received no cash. The company is revenue-rich and cash-poor.

GAAP Changes to Revenue Recognition Policies

On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606, regarding revenue from contracts with customers. ASC 606 provides a uniform framework for recognizing revenue with contracts. The old guidance was based on industry specific guidance, which created a system of fragmented policies. The new guidance is industry-neutral and therefore more transparent. Most companies have until 2018 to implement changes.