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What is the Revenue Recognition Principle?

October 20, 2015

Questions about GAAP:

What is the revenue recognition principle and why is it important?

Facts:

The revenue recognition principle states that revenues are recognized when they are earned even if payment has not yet been made.

Discussion:

The revenue recognition principle is one of the Generally Accepted Accounting Principles (GAAP). GAAP is basically the rule book that accountants follow when preparing financial statements. Under the accrual basis of accounting, revenues are recorded as soon as the product has been sold or a service is done. It does not matter when the cash is received as cash can be received in advance or at a later date in most circumstances. For example, if a corporation provides consulting services at an agreed price of $1,000, it should recognize this revenue as soon as the work is performed. If the cash was not received until after the fiscal year, then there would be an accrual set up as a receivable and revenue would be recorded. If cash is received in advance, the payment is recorded as a liability and not as revenue. Unearned revenue or customer deposits are common names for this liability. Once the work has been performed, the payment will be reallocated from the liability account to revenue. There are some criteria for determining when revenue is recognized:

  • When risks or rewards are transferred from seller to purchaser
  • The seller has no control over goods or services that have been completed
  • Collection of payment can be reasonably assured
  • When the amount of revenue can be reasonably measured
 

Alternatively, under the cash basis of accounting, revenues are recorded when a cash payment is received. For example, using a scenario where payments made after the service is complete, revenue would only be recognized when the cash is received which could have been in the next fiscal year. When revenue is recognized properly, it is useful to managers, investors and bankers to make important decisions. GAAP allows the readers of the financial statements to review meaningful and comparable information.

If you would like more information on this topic, please contact a member of the Empire CPA team by filling out the contact form below.

Canadian and foreign tax laws are complex and have a tendency to change on a frequent basis. As such, the content published above is believed to be accurate as of the date of this post. Before implementing any tax planning, please seek professional advice from a qualified tax professional. Empire, Chartered Professional Accountants will not accept any liability for any tax ramifications that may result from acting based on the information contained above.

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