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Image source: Getty Images If your business uses accrual accounting, you should know and understand the revenue recognition principle, sometimes known as the revenue principle. Why not take a few minutes and learn more about the revenue recognition principle and why it is important to your business. Overview: What is the revenue recognition principle?No matter what type of accounting your business is using, the revenue recognition principle remains the same. The revenue recognition principle says that revenue should be recorded when it has been earned, not received. The revenue recognition concept is part of accrual accounting, meaning that when you create an invoice for your customer for goods or services, the amount of that invoice is recorded as revenue at that point, and not when the money is received from the customer. This is one of the major differences between accrual basis accounting and cash basis accounting, since with cash accounting, revenue is recognized when payment is received, not when it’s earned. Requirements for revenue recognitionThe revenue recognition principle requires that you use double-entry accounting. Here are some additional guidelines that need to be followed in regards to the revenue recognition principle:
What does the revenue recognition principle mean for businesses?The revenue recognition principle enables your business to show profit and loss accurately, since you will be recording revenue when it is earned, not when it is received. Using the revenue recognition principle also helps with financial projections; allowing your business to more accurately project future revenues. Recognizing revenue properly is also important for businesses that receive payment in advance of services, such as businesses that provide service contracts that require payment up front. In order to recognize revenue properly, any business that receives payment upfront for services to be rendered must recognize that revenue only after the services have been performed. For instance, if you offer a yearly support contract to your customers for $12,000 annually, you would recognize revenue in the amount of $1,000 monthly for the next 12 months. Example 1
This is to record the initial customer deposit of $12,000. Example 2
This is to record the January payment since it has now been earned. In Example 1, you would debit your cash account, since the money will be deposited. However, instead of applying it to an income account, you would place it in a Client Prepayment account, which will be gradually reduced until the complete $12,000 has been earned. In Example 2, you would debit the Client Prepayment account, since you are reducing the balance by $1,000, while crediting your income account for the month of January, continuing to do a journal entry each month through the month of December in order to properly account for the earned revenue. Example of the revenue recognition principleHere are two simple revenue recognition examples:
FAQs
Why understanding the revenue recognition principle is importantIn order to produce accurate financial statements, it’s important to understand and properly use the revenue recognition principle. Using this principle allows you to record your revenue as it’s earned, thus providing a more accurate profit and loss statement, a must if you’re looking for investors or business financing. If you’re currently in the market for small business accounting software that will help you better track revenue, be sure to check out The Ascent’s accounting reviews. Expert-picked business credit cards with rich rewards and perksCash back, travel rewards, 0% intro APR financing: all of these can be great credit card perks for business owners. But how do you find the right business credit card for you? There are tons of offers on the market today, and sifting through them to find the right one can be a big hassle. So we've done the hard work for you. Get started with one of our top business credit card picks of 2022 today. What is the revenue recognition principle?Essentially, the revenue recognition principle means that companies' revenues are recognized when the service or product is considered delivered to the customer — not when the cash is received. Determining what constitutes a transaction can require more time and analysis than one might expect.
When should revenue be recorded?Revenues are recognized when earned, not necessarily when received. Revenues are often earned and received in a simultaneous transaction, such as the case when a customer makes a retail in-store purchase.
When should revenue be recorded quizlet?Accrual-basis accounting requires that revenue be recorded when it is earned, regardless of when it is received, and that expenses be recorded when they are received, regardless of when they're paid.
What type of accounting system records revenue only when the money is actually received?Cash basis accounting is a method where revenue is recorded when the cash is actually received; likewise, expenses are recorded when they are paid. Cash accounting does not acknowledge or track accounts receivable or accounts payable. For that reason, the method is best for small businesses that do not stock inventory.
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