Revenue recognition principles and practices

Revenue recognition is a method by which one can determine when certain income can be recognized or considered as revenue. When we say "to recognize" we actually mean to record. This principle is used by several businesses and organizations to ensure that their accounting records are up-to-date and accurate. There are typically three important guidelines for revenue recognition. (Taub, 2011)

Revenue is recognized when earned: In this case the earnings process must be fully complete. This means that revenue can only be recorded into the book of accounts when all transactions between a seller and the customer are complete. The seller of a particular product or service must have no obligation or duty towards the customer. So, the two types of transactions involved here are there selling of a product from inventory and the rendering of a service. Once the product is delivered to the final customer or the service is rendered, the revenue account may now be credited while the cash account may now be debited.

An example of this guideline for revenue recognition would be that suppose there is a large company (let's call it company A) that sells parachute bags in bulk. If company A gets an order from a customer to deliver 500 parachute bags by a particular date, company a will only credit its revenue account when it delivers the bags to the customer. If there is any return policy attached to the transaction, the account will be credited once the period of returning goods expires.

Proceeds from selling products and services need not be in cash: This statement typically means that when a product or service is sold it is not necessary that at the time of sale, cash must be received. Non-cash proceeds, which can be anything that is not cash, can be used to carry out the transaction. For example, in the pre-modern times when the use of currency was not very common, people used to exchange their personal goods in order to purchase other goods or services. Today, however, the most common kind of non-cash proceed is credit sales. This means that a customer and the seller have an agreement with each other where the customer promises to pay the amount in cash for a certain good or service at a particular future date. Here the seller will record an increase in assets by debiting accounts receivable account and will also record a decrease in the asset account by crediting it to show a decrease in the inventory due to sales. This of course, will be different for services.

An example for this situation would be that suppose Mr. John has $1,000 and wants to buy a new BBQ grill that costs $1,500. He is short of $500 and so he may purchase the grill on credit from the store he is buying from and may give the full amount on a specified future date. The store will record the transaction by debiting and crediting the asset account. If Mr. John were to keep a record of his own transaction he would credit his liability account from the money he owns to the store.