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Revenue Recognition Principle

Why is the Revenue Recognition Principle Important in Accounting?

Are you coping with accountancy and its various principles? Well, as far as the revenue recognition principle is concerned, help is here!
BusinessZeal Staff
Last Updated: Jun 3, 2018
Let's first briefly discuss the two accounting bases. Pecuniary transactions may be recorded under either the cash basis or the accrual basis of accounting. Under the former, only those transactions for which actual cash (real time receipts of payment which may be in terms of cash or check) has been exchanged in the given accounting period, are recorded as either income or expenditure. Whereas under the latter, all such transactions for which any income is earned (whether or not actually received) or any expense is incurred (whether or not actual payment is made) in a given accounting period, are recorded.

The principle of revenue recognition, which is included among the Generally Accepted Accounting Principles (GAAP), is an important component of the accrual basis of accounting and determines the conditions where revenue is realized for a given accounting period, irrespective of whether the cash has been received or not.

Meaning

Nowadays, not all transactions are fulfilled on a cash-on-delivery basis. Most of the time, the goods or services are delivered or rendered first and the payment is made at a later date, or maybe even in several installments. However, irrespective of whether the entire payment is received within the given accounting period, such a revenue is definitely earned and belongs to that period and as such, needs to reflect in the books of accounts. Contrarily, even if an advance payment is received for goods that are to be delivered in a future period, such revenue is not included in the books of the present period, as they are accruing to a future accounting period.

In conformity with this principle, revenue is differentiated as 'accrued' and 'deferred'. Accrued revenue is when goods are delivered or services are rendered, but payment is not yet received. Deferred revenue is when payment is received, but the goods or services are not delivered or rendered respectively, and would be completed at a future date. This can be better understood from the following example:

ABC & Sons signed a contract with Messrs XYZ on 15 December 2010, to deliver 10,000 units of cement to the latter on 25 January 2011. The price quoted by ABC & Sons was USD 30,000 and Messrs XYZ agreed to pay 50% on the spot and the rest on delivery. In accordance with this agreement, Messrs XYZ paid USD 15,000 in advance. However, while taking delivery on 25 January 2011, they cited some financial difficulty and paid only USD 8,000, promising to pay the remaining amount on 3 April 2011. Assuming the accounting period followed by ABC & Sons to be 1st April to 31st March, the entire amount of USD 30,000 will be recorded as revenue for the accounting period of April 2010 - March 2011, since it is earned on 25 January 2011. It may be broken up into two parts though-a combined amount of USD 23,000 (USD 15,000 + USD 8,000) will be entered as revenue received and the balance amount of USD 7,000 will be narrated as outstanding revenue.

Relation with Matching Principle

The matching principle, one of the cornerstones of accrual accounting, seeks to match the expenses and revenues with the accounting periods in which they are incurred or earned. As such, it is a conclusive explanation that combines all aspects of accrual accounting including that of revenue recognition. Importance of this principle lies in the fact that earnings can be traced back to the exact accounting period irrespective of whether the cash is pre-received or outstanding. In case of pre-receipt, the real earning status is not lost and true period is not distorted. In case of accruals, a record is present of the actual earnings and collectible amounts. If accounting is done on cash basis, keeping track of such issues may require extra efforts and resources, but the accrual basis makes sure that these untimely revenue issues reflect in the master account itself.

However, there are a few exceptions to the principle of revenue recognition. In case of long-term contracts such as construction, mining, etc., the billing is permitted at various points of the contract period and it is not necessary for the contractor to wait till the completion of the contract and transfer of ownership. Also, contracts involving buyback agreements and future returns do not follow this principle, because these cannot be clearly identified as actual sales.