Revenue Recognition Principle

A crucial question for many companies is when to recognize revenue. Revenue recognition generally occurs (1) when realized or realizable and (2) when earned. This approach has often been referred to as the revenue recognition principle. Acompany realizes revenues when it exchanges products (goods or services), merchandise, or other assets for cash or claims to cash. Revenues are realizable when assets received or held are readily convertible into cash or claims to cash. Assets are readily convertible when they are salable or interchangeable in an active market at readily determinable prices without significant additional cost. 

In addition to the first test (realized or realizable), a company delays recognition of revenues until earned. Revenues are considered earned when the company substantially accomplishes what it must do to be entitled to the benefits represented by the revenues.12 Generally, an objective test, such as a sale, indicates the point at which a company recognizes revenue. The sale provides an objective and verifiable measure of revenue—the sales price. Any basis for revenue recognition short of actual sale opens the door to wide variations in practice. Recognition at the time of sale provides a uniform and reasonable test.

During Production. A company can recognize revenue before it completes the job in certain long-term construction contracts. In this method, a company recognizes revenue periodically, based on the percentage of the job it has completed. Although technically a transfer of ownership has not occurred, the earning process is considered substantially completed at various stages of construction. If it is not possible to obtain dependable estimates of cost and progress, then a company delays revenue recognition until it completes the job. 

At End of Production. At times, a company may recognize revenue after completion of the production cycle but before the sale takes place. This occurs if products or other assets are salable in an active market at readily determinable prices without significant additional cost. An example is the mining of certain minerals. Once a company mines the mineral, a ready market at a quoted price exists. The same holds true for some agricultural products.

Upon Receipt of Cash. Receipt of cash is another basis for revenue recognition. Companies use the cash-basis approach only when collection is uncertain at the time of sale. One form of the cash basis is the installment-sales method. Here, a company requires payment in periodic installments over a long period of time. Its most common use is in retail, such as for farm and home equipment and furnishings. Companies frequently justify the installment-sales method based on the high risk of not collecting an account receivable. In some instances, this reasoning may be valid. Generally, though, if a sale has been completed, the company should recognize the sale; if bad debts are expected, the company should record them as separate estimates.
To summarize, a company records revenue in the period when realized or realizable and when earned. Normally, this is the date of sale. But circumstances may dictate application of the percentage-of-completion approach, the end-of-production approach, or the receipt-of-cash approach.