Revenue Recognition Principle: Steps, Application and Importance

When it comes to the accrual accounting and the principles associated with it, there is just one principle that always comes to the minds of the people, and that is known as the Revenue Recognition Principle.

This principle states that the companies always need to make sure that they are recording the revenues at the time of the earning or the recognition even though the cash has not yet arrived.

In simple terms, you can understand revenue recognition as some particular conditions that are used for recognizing the revenues. Here we are going to discuss the revenue recognition principle in a more in-depth fashion, so without any further ado, let us start unraveling the mysteries-

First of all, it is important to understand what exactly the revenue recognition principle is and hence, we are here to give a short introduction to the principle and what it can do.

Meaning of Revenue Recognition?

Talking about revenue recognition, it can be defined as a GAAP or a generally accepted accounting principle.

This principle helps the business in determining several specific conditions in which the revenue for a business can be easily recognized and accounted for.

When does revenue recognition occur?

The occurrence of revenue recognition will happen at the time when goods are sold and delivered or when the services are exchanged.

Two conditions for the recognition of revenues are-

1. Completion of Earning Process
2. Exchange transaction

The revenue of a particular business is recognized generally when there is a particularly critical event which has occurred, and the people can measure the revenue amount. However, there might be some other situations where there can be some exceptions made.

The revenue recognition principle touches on the same particular grounds as the matching principle. This is said because the activity is properly recorded in the certified period when it has occurred.

The principle in question here is specific towards the recording of the revenue in the entire period of accounting. However, the matching principle that we are talking about in here focuses on the recording of the expenses.

Why is the Revenue Recognition Principle Important?

There is simply no doubt about the fact that business performance is always affected by revenue. There is a lot that always depends on the sale that is being made by the company.

The regulators are always provided with the information on how appealing the offer can be for the companies who want to push the limits based on revenue. This is especially the case when the revenue is not properly collected after the completion of work.

Many attorneys always bill their clients according to the billable hours and then present the invoice after the completion of the work.

So, it is really important for the analysts and the companies to know how the policy of revenue recognition would work for a certain business according to the standards of the industry.

This principle also plays an important role in ensuring that the comparison is made properly between the metrics with the help of the income statement.

Working of Revenue Recognition Principle

According to the revenue recognition principle, there is a combination of the matching principle as well as the accrual accounting that enables it to function adeptly.

The revenues are properly recognized when there is earning and recognition; however, it doesn’t rely on the receiving of the payment. The term realization here means that the services or the goods have been received by the people, but the payment is due or supposed to happen later on.

The earned revenue that we are talking about in here is that the services have been performed. Apart from that, the activity of revenue generation needs to be completed to include the revenue in between the period of accounting.

Steps of Revenue Recognition Principle

Now that you know a little bit more about revenue recognition let us delve more into the details. To follow the revenue recognition principle properly, some steps need to be followed accordingly-

1. Identification of the customer contract
2. Identification of different obligations given in customer contract
3. Determination of the price of the transaction
4. Allocation of the Price of Transaction to the Performance Obligations
5. Recognition of the Revenue at the time when Performance Obligations are met

Here we are going to mention these steps in a details manner so that the people can have an idea of what to expect when it comes to the revenue recognition principle and how to follow it.

#1 Identification of The Contract

To follow the important revenue recognition principle, one needs to make sure that there are some conditions which are fulfilled by the company properly. After the fulfillment of these conditions, a proper contract can be made according to it.

To identify the contract, the parties involved need to approve the contract. The particular contract in question here can be verbal, written, or just implied.

Also, the point of transfer, when it comes to the services, as well as the goods, needs to be identified as well. Along with that, the payment terms also need to be set properly.

It is also important to see whether the contract has some form of commercial substance or not. The payment collection also needs to be probably so that the contract can be formed in the best way for the people.

#2 Identification Of The Performance Obligations in Customer Contract

There are many different contracts which might have more than one obligations for the performance. Let us provide you with an example right here.

In the case of the car sale, which is provided along with a complimentary lesson of driving, there are two different obligations of performance. One would be the sale of the car, and the other one would be the providence of the driving lesson.

So, there is more than one obligation in the contract. Another one of the most important things that the people need to keep in mind is that if there are more performance obligations, then they need to be different from one another.

#3 Determination of The Price of Transaction

When there is a transaction that is being performed, the price of it is almost readily determined. However, some different contracts have got an amount already fixed according to the services or the goods that are being provided by the company.

Let us give you an example here as well so that you can have a proper understanding of what we are talking about. Let us say that the price of a particular car is about $20000 and there is a complimentary driving lesson which is being provided to the buyer.

So, in this case, the price of the transaction will be only $20000 since the driving lesson is completely free of cost.

There will be no addition of cost taken into account for the driving lesson. This is one of the most important things that one needs to always keep in mind to have the best results when it comes to the revenue recognition principle in the best sense.

#4 Allocation of The Price Of Transaction To The Performance Obligations

When it comes to the allocation of the price to the performance obligations, there are also some important things that one always needs to keep in mind.

If there are more performance obligations in the contract, then the price allocation to these obligations will be done based on the fact that the standalone price of the performance obligations is accurate.

#5 Recognition Of The Revenue According To The Performance Obligation

When it comes to the recognition of the revenue according to the principle, there are some other things that one always needs to remember to have the best of the results from the sale.

Well, the person needs to review all the conditions which are provided in the revenue recognition principle.

There are two conditions which say that the revenue of the sale would only be recognized in case the seller has already provided the buyer with the goods or the services which are expected from here.

So, the revenue would either be recognized at a particular point in time or over time as well.

Usages of the Revenue Recognition Principle

In the end, the only thing that we can say here is that the revenue recognition principle is probably one of the most important principles when it comes to the accounting of the revenue and the sales.

That is one of the main reasons why it is so popularly used by people and businesses from all over the world.

Also, another reason why people want to follow this Revenue Recognition Principle is that it helps in ascertaining the loss as well as the profit margin in real time. This is essential when it comes to maintaining the financial credibility of a business.

With the help of the revenue recognition principle, a company would be able to have a proper balance when it comes to looking after the cash which is going out and the revenue that is coming in too.

This is certainly a very accurate picture which the company needs for the financial stability and health of the business.

Not just that but revenue recognition also helps in seeing over the fact that the company is properly able to attract the stockholders as well.

So, these are some of the important reasons why people value this particular principle so much when it comes to business.

Wrapping it up!

Now we have come to the concluding note of this post, and we hope you would have understood the significance of the Revenue Recognition Principle in business management.

Still, have any doubts about the role of revenue recognition? Feel free to share your queries in the comments below.

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