We all know what revenues are and what an important metric it is for the performance of a business. But many business owners wonder when they can count income as revenue in the income statement, or in other words, when to recognize the revenue. Should you recognize revenue when you receive the order or when you delivered the service? And does it matter if this is a “good” customer with a long customer history, or a new customer who is purchasing for the first time?
Revenue recognition cannot be seen in black and white. There are many grey areas in accrual accounting because the economic event is typically recorded before the financial exchange takes place. There must be, therefore, guidelines that identify when and how revenue can be recognized. In this post, we will discuss the practices that affect how and when revenue is reported on your income statement.
In general, revenues can be recognized if they have:
- Persuasive evidence that an “agreement” exists between the supplier and the customers – such as a purchase order, a filled online order form or a receipt.
- Delivery of goods or services has occurred – you can’t recognize the revenues until you’ve delivered – even if you’ve been paid for the service in advance!
- Fee is fixed or determinable – there is a contract or list price.
- Collection is probable. If you believe that there is only an 80% chance of getting paid – you should only recognize 80% of the sale as revenue.
Let’s take two relatively simple examples to show how to apply these rules in real life situations:
Revenue Recognition at the Point of Sale
The most obvious point that revenue can be recognized is at the point of sale, when then buyer takes immediate ownership of the purchased goods. When you go to the corner market and buy a gallon of milk, the milk goes home with you and the storeowner takes the cash due. If you pay with a credit card, that card is assurance of payment, and even if the shop owner doesn’t have the cash in hand, he will soon enough.
The revenue earned from the sale is reported in the income statement for the current accounting period.
For retailers especially, the right of return needs to be considered. If a company, say on online clothes retailer, expects a high rate of return for items purchased, it is not in their best interest to record revenues immediately at the point of sale. In cases like this, it is better to recognize revenue only after the period of return has passed, say 30 days.
Recognizing Revenue for Services Rendered
Recognizing revenues for services rendered differs from point of sale, as the buyer doesn’t necessarily take home a tangible object (a gallon of milk). Instead, the buyer and service provider have an agreed upon contract. Let’s look at a web designer that has been commissioned a 1-month project to develop a website. The designer charges $4,000 for the project, of which $1000 must be paid up front, and $1000 will be paid at the end of each of 3 milestones, upon the client’s approval (within reason).
If the first payment is made during Q1, the designer can recognize that revenue upon receipt provided that she isn’t required to deliver anything for that payment (but she is paid because, say, she needs to perform some research).
The following payments should be recognized only when the customer has approved them. Even if both parties agreed that the project would take 1 month, extenuating circumstances may extend the date of delivery. It is not in the designer’s best interest to record that revenue until the customer’s approval is received, be it in Q1 or Q3.
Due to the far-from-accurate nature of the revenue recognition principles, companies sometimes play around with revenue recognition to make their financial figures look better. If a company wants to hide the fact that sales have been down that year, it may choose to recognize income that hasn’t yet been collected in an effort to boost the numbers. Though this happens, we strictly advise you to avoid it. Just take a look at what happened to Enron!