Lesson Objectives:- Defining revenue recognition
- An example of how the concept is used
- Revenue recognition criteria
We will start looking at the concept of revenue by diving into the topic of revenue recognition. Revenue recognition is simply the principles that guide what accounting period that revenue is recognized in.
The fundamental question that the revenue recognition principle answers is: When should revenue be recorded?
To understand the answer to this question, let's first take a look at an example of where we would need to use the concept of revenue recognition and the criteria that we need to follow.
Let's say a building materials company is selling pre-constructed sheds that their builders are responsible for assembling. If you think of the timeline of stages involved in the sale of the shed, there are multiple steps involved before the revenue can be collected for the sheds. The builders first create the blueprint for the shed and gather the raw materials. They then construct the shed according to the plans and prepare it for shipment.
When a pre-assembled shed is purchased, it must be delivered and then the customer will be billed for the sale. The final step of this process would be when the company collects the revenue in accounts receivable for the sale of the shed.
Let's say one of the pre-assembled sheds is sold for $1,200. In order to determine when to recognize the revenue for this sale, let's first look at the criteria involved with revenue recognition.
There are two criteria for determining when we should recognize revenue: performance and collectibility. For performance, the company must have a firm idea of the price that they are charging based on historical results and value, and the risk and rewards associated with the revenue should have transferred substantially. For collectibility, there must be a greater chance than not of the payment being collected.
We always use the term "reasonably" when looking at the recognition criteria because there is often not 100 percent certainty until the funds are actually received. Still, we need to be able to report the revenue in the appropriate accounting period.
Always adhere to this criteria of looking at the performance and collectibility when determining when to recognize revenue.
If we look at the example of the pre-assembled shed in accordance with this criterion, the revenue would be recognized when the shed is shipped to the client. Most likely, it would be when the shed arrives at the customer site to ensure that there are no damages or issues with the finished product and the revenue would be collectable.
In the next lesson, we will dive further into the topic of revenue recognition and look at some examples of how the criteria comes into play for consignments and long term contracts.