Revenue Recognition

When can a company recognize revenue? This question is often confusing for owners and managers of small to medium size businesses.  Revenue recognition differs depending on the nature of your business and whether you are using the accrual or cash method of accounting. We will first look at revenue recognition for accrual based accounting.

When a customer commits to buy your product or service, your sales department may proudly say they’ve made a sale. From an accounting standpoint, that it not yet a sale—it’s an order. An order is usually accompanied by a purchase agreement or contract that will specify 1) what the customer is getting, 2) when it will be delivered, 3) when you will invoice them, and 4) when they must pay. The customer is not concerned about when your company recognizes revenue; that has nothing to do with them. Revenue recognition is between your company and the government’s requirements for revenue recognition.

Revenue is recognized when your company ‘earns’ the money. Money is earned when a product or service is ‘delivered ‘to the customer. Revenue recognition is easy for a retail business like a grocery store. The order is what a customer puts in his/her shopping cart. The customer goes to the check-out person who gives them an invoice. The customer pays and the grocery store immediately can recognize the revenue.

Revenue recognition is more complicated for project based companies. Construction Companies or software development firms do projects that may last many months or even years. They recognize revenue by a method called ‘Per Cent Complete.’ The signed contract represents the eventual total revenue on the project. The company will have estimated the costs and profit that made on the project. When the project is 25% complete, the company can recognize 25% of the revenue, costs and profits. Project based companies operate on estimated earnings, since they do not know the final profitability until projects are complete. This requires that they update the costs and projected profits as things change during a project.

For relatively small projects revenue may be recognized by the ‘Completed Contracts’ method. Using this method, revenue is not recognized until the project is 100% complete. It is possible for a company to have multiple revenue recognition methods. Each company is unique and needs to understand when and how its revenue is recognized.

Service companies in the United States can recognize revenue and costs on a cash basis for tax purposes. Using this method, revenue is recognized when the company receives cash from its customer and costs are recognized when bills to vendors are paid. A tax advantage occurs if the company can accelerate payments to vendors and delay receipts from customers.

Government rules and regulations apply to revenue recognition because government revenue comes from taxing earnings on the revenue. It is essential that all business management teams understand how revenue is recognized in in their company.