Revenue recognition principle

Revenue is the income of a business earned from its normal business activities and is often considered as one of the key performance indicators of the business. Revenue recognition principle is an important principle of accounting which requires that revenue should be recorded as and when the performance obligation is satisfied, such as promised goods are delivered to the customer or promised services are rendered to the customer, and the consideration for the performance obligation can be measured reliably.

It is worth noting that there is nothing mentioned about the cash receipt related to revenue. Revenue is recognized as per accrual concept and its recognition is linked with earning of income by satisfying the performance obligations regardless of the related cash receipt status. For instance, Company XYZ has agreed with its customer that payment for the sale of goods can be made after 30 days of the delivery of goods. Company XYZ has sold and delivered some goods to its customer on 1 September but has not received cash against it. Cash is received on 30 September. When should the revenue be recorded? As per revenue recognition principle, it should be recorded on 1 September, when the promised goods are delivered to the customer.

Let’s take a look at another example which will clarify the logic behind this principle. A Company has been awarded a contract for the construction of a road. Total contract value is $300,000 and is expected to be completed in three years due to difficult mountain terrain. It is agreed that the Company will use its own funds to construct the road and will be paid full amount at the time of completion of the project. If the revenue is recorded according to cash basis of accounting, all of the revenue will be recorded in third year and there will be no revenue in the first two years, which is not the true representation of the performance of the Company. As the Company is working on the project, it is continuously satisfying its performance obligation and revenue should be recorded on the basis of percentage of completion. For instance at the end of first year, 30% project is completed, at the end of second year, 70% project is completed and at the end of third year, 100% project is completed. Revenue should be recorded as follows:

  • Year 1: Revenue of $90,000 should be recorded
  • Year 2: Revenue of $120,000 should be recorded
  • Year 3: Revenue of $90,000 should be recorded

Similarly, if the payment for sale of goods or services is received in advance, it should be treated as a liability of an entity and revenue should be recorded only when related goods are delivered or related services are rendered to the customer.