Revenue recognition principle are inflows of assets resulting from providing a product or service to a customer. The revenue recognition principle is also called the realization principle. Recognition of revenue is the act of recording revenue in the accounting records and reporting it in the income statement. Revenue is generally recognized when
a) Earned and
b) Either realized or realizable
In the first case, Revenue is considered as earned when the entity has done the exchange of goods or services to its customers. i.e when services are rendered or the seller transfers the ownership of goods. sold to the customer. Amount that is realized or realizable is not until it is earned. Mainly, revenue should be recognized at the tie of sale of goods or rendering of services or assets are exchanged for cash. Revenues are realizable when goods, services or assets are exchanged for cash or other assets to be realized at any future date.
Revenue recognition principle Example:
1. When cash is realized
A customer buys a compact disk from a shop of Eastern Plaza for $50 cash; the shop realizes $.50 as revenue
2. When cash is realizable:
A customer buys a compact disk from a shop of Eastern plaza for $50 to be paid in future date, the shop can record $50 as revenue provided that the customer is expected to pay the dues.
In both the cases, the earning process is complete.
3. Suppose, a customer pay in advance of taking delivery of a product or service. Because the earning process is not complete. the seller must not recognize revenue.
Note to the readers:
- When the earning process is complete i.e the entity acquires the right to collect sale proceeds (Sales price) from the customer and when the collection is receivable at some future date is recorded as revenue. But in this case, revenue is the amount that is reasonably certain to be realized. Otherwise, we cannot recognize the amount as revenue.
- The timing of revenue recognition is important. Revenue should be recognized in the period in which it s earned, not in the period in which it is received. An income statement of a particular period should report the revenue of that period only.
- In absence of this principle, accounting people recognize that amount which is received in cash and earned. Realizable amount cannot be recognized as revenue even after the earning process is complete. There will be a disaster at the end of the day. as most business deal with customers on credit basis. For instance, a business entity earn $50,000 cash from its sale in 2004. In addition to this the entity has also a credit sale of $4,00,000 (amount to be realizable) in the same year. Total expenses of the entity are $3,00,000 in 2004. Net income will be a negative figure i.e net loss $2,30,000 in 2004!
Whereas, if we recognize the realizable amount as revenue, total revenue comes as $4,50,000; expenses $3,00,000. Net income will be $1,50,000 in 2004.