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Revenue Recognition Explained

By Alan Hart, MBA

I have seen people confuse the term revenue recognition with billing or invoicing or simply recording sales on the company books. While it may seem logical that when you bill your clients or customers for services performed or products shipped, you are automatically entitled to declare these sales as revenue earned, there is a structured and defined method to help you determine what is actually earned revenue and when exactly it is earned. In addition to applying the correct method, which is something that GAAP (Generally Accepted Accounting Principles) requires, it will also give you the confidence that your accounting policies and procedures are carried out as expected in your particular business situation and for the actual transactions that take place. It is interesting to note that in larger organizations, especially publically traded companies, revenue recognition issues has been the largest single source of restatements (re-issuing or re-filing financial statements and periodic reports at a later date due to errors or omissions) in the past 15 years. This can be avoided if revenue recognition principles are followed.

The fundamental principles of revenue recognition are fairly simple and make sense when you stop and think about what actually occurs when your company’s services are rendered or goods are shipped or other activities take place in the course of performing your obligations to your customers.

Now what exactly is revenue recognition? In simple words, it is properly recording revenue (sales) transactions in the correct amounts and in the correct accounting periods (e.g., fiscal quarter) after meeting certain conditions associated with these transactions. Since recognized revenue appears on financial statements, we need to pay close attention to its appropriateness in each reported accounting period.

According to GAAP this is what needs to happen before you can book the sale or recognize the revenue from a transaction (note that the formal rules are numerous and specific to each type of transaction and industry, and the actual language used is more formal, but the fundamental principles are simple):

1. The revenues must be realized or realizable

• Realized means you received payment for goods delivered or services performed (example: cash sale), or a claim to cash (example: in form of accounts receivable).
• Realizable means you received assets in exchange for the goods delivered or services provided and these assets can be readily converted to cash or claims to cash.

and,

2. The revenues must be earned

• This means that your company has completed its obligation customers under the sales agreements. For example: Products have been shipped to customers, services were provided and were completed, and you are entitled to receive the benefits represented by the revenue, which means your earning process is complete.

These basic principles apply to four types of sales transactions your company may be engaged in:

1. You ship products and recognize revenue at the date of delivery to customers (generally the date the goods leave your warehouse).
2. You provide services and recognize revenue when services have been performed and you are entitled to bill the customer.
3. You allow others to use your assets in exchange for rent (example: you leased a portion of your building to another company), interest (example: you loaned money to another entity), or royalties (example: you licensed your product design to another organization), and recognize revenue periodically as these assets are used.
4. You sell assets and recognize gains (or losses) at the date of sale.

In practice there are many exceptions and departures from these simple principles and that depends on the type of business or industry or type of sales transactions your company is engaged in. The two general departures are:

1. Revenue recognition prior to delivery date.

• Example: You are engaged in long-term construction projects. A portion of the contract amount is recognized as revenue in each period, assuming the percentage of completion method is appropriate in this situation. Here, a good portion of the revenue is recognized prior to the delivery date of your finished project.

2. Revenue recognition after the delivery date.    Examples:

• You sell your products to a wholesale distributor who agrees to pay you only for goods sold through to their customers. This is in reality a consignment agreement, so revenue should only be booked for products that were sold through in each accounting period.
• You sell subscriptions to your publication and charge an annual fee payable in advance each year. You must defer revenue for the entire amount at the beginning of each year and recognize (record) revenue in each period services were provided to your customers. The deferral (liability) account will be periodically amortized until its balance will reach zero at the end of the year, only to be charged again upon renewal of that subscription.
• Your customer specifically requests in their purchase order that you ship your goods to them FOB (free on board) destination (their warehouse location). Revenue recognition in this case can only take place after the goods are actually delivered. If the delivery date falls in a future accounting period, it must be recorded in that future period and not in the period it was shipped.

Under most circumstances you may recognize revenue when shipping products or performing services, but you will have to maintain adequate reserve accounts such as a reserve for doubtful accounts (to allow for customer receivables that may be eventually written off due to non-payment), sales returns reserves, warranty reserves and other reserves.

There are many additional examples and situations that require a specific treatment of revenue recognition. They are all defined by FASB (Financial Accounting Standards Board - http://www.fasb.org, the organization responsible for creating and maintaining GAAP), with detailed description on how to recognize revenue according to your situation, industry and type of sales.

With the advent of modern accounting and ERP software, many of which were designed for small and medium size organizations, revenue recognition transactions can be automatically handled by the system, after proper and careful setup. The majority of revenue recognition treatments can be implemented using the standard software applications and usually only a few will require slight modifications to the standard software.

Summary

Knowing how to apply correct and current GAAP revenue recognition principles in your organization will ensure that users of financial statements will receive accurate revenue and cost of revenue data in the correct reporting period. Management can benefit from accurate revenue recognition by being able to make timely business and operational decisions. Restatements of financial statements can be prevented.

Alan Hart Bio

Alan Hart is Principal Consultant at Pacific Shine Group in Portland, Oregon, with responsibility for client business development and hands-on client project implementations. Prior to starting Pacific Shine Group, he worked in various executive accounting and finance positions with technology and growth companies. Notable is his 18 years in the hi-tech manufacturing industry where he served as Controller, Vice President of Finance and CFO of several privately as well as publically held companies.

Combining his skills and experience in engineering with deep understanding of technical accounting, he is able to assist small and medium-size manufacturing companies establish GAAP compliant accounting and reporting systems,

Alan holds an MBA degree from the University of Birmingham. He is also holds a degree in Marine Engineering and Naval Architecture.

Alan can be reached at (310) 384-1453 or alan.hart@pacificshinegroup.com