Definition: The revenue recognition principle is an accounting principle that requires revenue to be recorded only when it is earned. It means that revenues or income should be recognized when the services or products are provided to customers regardless of when the payment takes place. In other words, companies don’t have to wait until they receive cash from their customers in order to record income from the sales. This is consistent with the accrual basis of accounting.
What Does Revenue Recognition Principle Mean?
This principle is important because companies can’t record revenues whenever they feel it. There has to be a set standard. If companies record revenues too early, their income statements will show more profits than they actually earned in that period.
The opposite effect will happen in later periods. The revenues that were previously recorded too early will now be missing from future periods and cause those financial statements to have lower profits.
As you can see, incorrect income reporting causes a ripple effect that changes the current year’s reports and several future years’ reports.
Example
The revenue recognition principle has three main concepts. First, revenues can only be recorded when they are earned. A lawyer can only record income after he or she has performed a service—not before.
Second, the service company doesn’t have to collect cash from the sale. Most companies have accounts receivable with customers and even allow store credits. Cash is not necessary.
Third, the earned revenue is recorded as the amount of assets received for the product or service. For example, if a lawyer agreed to represent a client for $5,000 in cash and a boat worth $10,000, the lawyer would record revenue of $15,000 because this is the total amount of assets he received for his services.
