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The revenue recognition principle is a cornerstone of accrual accounting together with matching principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realised or realisable, and are earned (usually when goods are transferred or services rendered), no matter when cash is received. In cash accounting – in contrast – revenues are recognized when cash is received no matter when goods or services are sold.
Cash can be received in an earlier or later period than obligations are met (when goods or services are delivered) and related revenues are recognized that results in the following two types of accounts:
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Received advances are not recognized as revenues, but as liabilities (deferred income), until the conditions (1.) and (2.) are met.
Recognition of revenue from four types of transactions:
In practice, this means that revenue is recognized when an invoice has been sent.
Accrued revenue (or accrued assets) is an asset such as proceeds from a delivery of goods or services, at which such income item is earned and the related revenue item is recognized, while cash for them is to be received in a latter accounting period, when its amount is deducted from accrued revenues. It shares characteristics with deferred expense (or prepaid expense, or prepayment) with the difference that an asset to be covered later is cash paid out to a counterpart for goods or services to be received in a latter period when the obligation to pay is actually incurred, the related expense item is recognized, and the same amount is deducted from prepayments
Deferred revenue (or deferred income) is a liability, such as cash received from a counterpart for goods or services which are to be delivered in a later accounting period, when such income item is earned, the related revenue item is recognized, and the deferred revenue is reduced. It shares characteristics with accrued expense with the difference that a liability to be covered later is an obligation to pay for goods or services received solo from a counterpart, while cash for them is to be paid out in a later period when its amount is deducted from accrued expenses.
For example, a company receives an annual software license fee paid out by a customer upfront on the January 1. However the company's fiscal year ends on May 31. So, the company using accrual accounting adds only five months worth (5/12) of the fee to its revenues in profit and loss for the fiscal year the fee was received. The rest is added to deferred income (liability) on the balance sheet for that year.
Advances are not considered to be a sufficient evidence of sale, thus no revenue is recorded until the sale is completed. Advances are considered a deferred income and are recorded as liabilities until the whole price is paid and the delivery made (i.e. matching obligations are incurred).
The rule says that revenue from selling inventory is recognized at the point of sale, but there are several exceptions.
This exception primarily deals with long-term contracts such as constructions (buildings, stadiums, bridges, highways, etc.), development of aircraft, weapons, and space exploration hardware. Such contracts must allow the builder (seller) to bill the purchaser at various parts of the project (e.g. every 10 miles of road built).
This method allows recognizing revenues even if no sale was made. This applies to agricultural products and minerals because there is a ready market for these products with reasonably assured prices, the units are interchangeable, and selling and distributing does not involve significant costs.
Sometimes, the collection of receivables involves a high level of risk. If there is a high degree of uncertainty regarding collectibility then a company must defer the recognition of revenue. There are three methods which deal with this situation: