What is Revenue?

Revenue is the value of all sales of goods and services recognized by a company in a period.
Revenue (also referred to as Sales or Income) forms the beginning of a company’s income
statement and is often considered the “Top Line” of a business. Expenses are deducted from a
company’s revenue to arrive at its Profit or Net Income.

Revenue Recognition Principle

According to the revenue recognition principle in accounting, revenue is recorded when the
benefits and risks of ownership have transferred from seller to buyer, or when the delivery of
services has been completed.
Notice that this definition doesn’t include anything about payment for goods/services actually
being received. This is because companies often sell their products on credit to customers, meaning
that they won’t receive payment until later.
When goods or services are sold on credit, they are recorded as revenue, but since cash payment is
not received yet, the value is also recorded on the balance sheet as accounts receivable.
When cash payment is finally received later, there is no additional income recorded, but the cash
balance goes up, and accounts receivable goes down.

Revenue Formula
The revenue formula may be simple or complicated, depending on the business. For product sales,
it is calculated by taking the average price at which goods are sold and multiplying it by the total
number of products sold. For service companies, it is calculated as the value of all service contracts,
or by the number of customers multiplied by the average price of services.

Revenue = No. of Units Sold x Average Price

Or
Revenue = No. of Customers x Average Price of Services
 
The formulas above can be significantly expanded to include more detail. For example, many
companies will model their revenue forecast all the way down to the individual product level or
individual customer level.

Revenue Forecast
Below is an example of a company’s forecast based on many drivers, including:
 Website traffic
 Conversion rates
 Product prices
 Volume of different products
 Discounts
 Return and refunds

Revenue on the Income Statement (and other financials)

Sales are the lifeblood of a company, as it’s what allows the company to pay its employees,
purchase inventory, pay suppliers, invest in research and development, build new property, plant,
and equipment (PP&E), and be self-sustaining. If a company doesn’t have sufficient revenue to
cover the above items, it will need to use an existing cash balance on its balance sheet. The cash
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can come from financing, meaning that the company borrowed the money (in the case of debt), or
raised it (in the case of equity).

In order to perform a comprehensive analysis of a business, it’s important to know how the three
financial statements are linked and see how a company either uses its sales to fund the business or
must turn to financing alternatives to fund the business.

Revenue Recognition
The Importance of Timing: Revenue and Expense Recognition
Revenue is recognized when earned and payment is assured; expenses are recognized when
incurred and the revenue associated with the expense is recognized.

Learning Objectives
Explain how the timing of expense and revenue recognition affects the financial statements

Key Points
1. According to the principle of revenue recognition, revenues are recognized in the period
earned (buyer and seller have entered into an agreement to transfer assets) and if they are
realized or realizable (cash payment has been received or collection of payment is
reasonably assured).
2. The matching principle, part of accrual accounting, requires that expenses be recognized
when obligations are (1) incurred (usually when goods are transferred or services rendered),
and (2) that they offset recognized revenues, which were generated from those expenses.
3. As long as the timing of the recognition of revenue and expense falls within the same
accounting period, the revenues and expenses are matched and reported on the income
statement.
Key Terms
 Incur: To render somebody liable or subject to.
 Accrual accounting: refers to the concept of recognizing and reporting revenues when
earned and expenses when incurred, regardless of the effect on cash.
 Matching principle: An accounting principle related to revenue and expense recognition in
accrual accounting.

Revenues and Matching Expenses

According to the principle of revenue recognition, revenues are recognized in the period when it is
earned (buyer and seller have entered into an agreement to transfer assets) and realized or
realizable (cash payment has been received or collection of payment is reasonably assured).

For example, if a company enters into a new trading relationship with a buyer and it enters into an
agreement to sell the buyer some of its goods. The company delivers the products but does not
receive payment until 30 days after the delivery. While the company had an agreement with the
buyer and followed through on its end of the contract, since there was no pre-existing relationship
with the buyer prior to the sale, a conservative accountant might not recognize the revenue from
that sale until the company receives payment 30 days later.

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Expense Recognition: The assets produced and sold or services rendered to generate revenue also
generate related expenses. Accounting standards require that companies using the accrual basis of
accounting and match all expenses with their related revenues for the period, so that the income
statement shows the revenues earned and expenses incurred in the correct accounting period.

The matching principle, part of the accrual accounting method, requires that expenses be
recognized when obligations are (1) incurred (usually when goods are transferred, such as when
they are sold or services rendered) and (2) the revenues that were generated from those expenses
(based on cause and effect) are recognized.

For example, a company makes toy soldiers and acquires wood to make its goods. It acquires the
wood on January 1st and pays for it on January 15 th . The wood is used to make 100 toy soldiers, all
of which are sold on February 15. While the costs associated with the wood were incurred and paid
for during January, the expense would not be recognized until February 15 th when the soldiers that
the wood was used for were sold.

If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as

expenses in the accounting period they expired (e.g., when they have been used up or consumed,
spoiled, dated, related to the production of substandard goods, or the services are not in demand).
Examples of costs that are expensed immediately or when used up include administrative costs,
R&D, and prepaid service contracts over multiple accounting periods.

The Effect of Timing on Revenues & Expenses

Often, a business will spend cash on producing their goods before it is sold or will receive cash for
goods it has not yet delivered. Without the matching principle and the recognition rules, a business
would be forced to record revenues and expenses when it received or paid cash. This could distort
a business’s income statement and make it look like they were doing much better or much worse
than is actually the case. By tying revenues and expenses to the completion of sales and other
money generating tasks, the income statement will better reflect what happened in terms of what
revenue and expense generating activities during the accounting period.

Current Guidelines for Revenue Recognition

Transactions that result in the recognition of revenue include sales assets, services rendered, and
revenue from the use of company assets.

Learning Objectives
Explain how the revenue recognition principle affects how a transaction is recorded
Key Points
1. Under accrual accounting, revenues are recognized when they are realized (payment
collected) or realizable (the seller has reasonable assurance that payment on goods will be
collected) and when they are earned (usually occurs when goods are transferred or services
rendered).
2. For companies that don’t follow accrual accounting and use the cash -basis instead, revenue
is only recognized when cash is received.
3. Revenue recognition is a part of the accrual accounting concept that determines when
revenues are recognized in the accounting period.
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 4. The matching principle, along with revenue recognition, aims to match revenues and
expenses in the correct accounting period. It allows a better evaluation of the income
statement, which shows the revenues and expenses for an accounting period or how much
was spent to earn the period’s revenue.

Revenue Recognition Concepts

The revenue recognition principle is a cornerstone of accrual accounting together with the
matching principle. They both determine the accounting period in which revenues and expenses
are recognized. According to the principle, revenues are recognized if they are realized or realizable
(the seller has collected payment or has reasonable assurance that payment on goods will be
collected). Revenues must also be earned (usually occurs when goods are transferred or services
rendered), regardless of when cash is received. For companies that don’t follow accrual accounting
and use the cash-basis instead, revenue is only recognized when cash is received.

Guidelines for revenue recognition will affect how and when revenue is reported on the income
statement.

Transactions that Recognize Revenue

Transactions that result in the recognition of revenue include:
1. Sales of inventory, which are typically recognized on the date of sale or date of delivery,
depending on the shipping terms of the sale
2. Sales of assets other than inventory typically recognized at point of sale.
3. Sales of services rendered, recognized when services are completed and billed.
4. Revenue from the use of the company’s assets such as interest earned for money loaned
out, rent for using fixed assets, and royalties for using intangible assets, such as a licensed
trademark. Revenue is recognized due to the passage of time or as assets are used.

The Matching Principle

The matching principle’s main goal is to match revenues and expenses in the correct accounting
period. The principle allows a better evaluation of the income statement, which shows the
revenues and expenses for an accounting period or how much was spent to earn the period’s
revenue. By following the matching principle, businesses reduce confusion from a mismatch in
timing between when costs (expenses) are incurred and when revenue is recognized and realized.

Recognition of Revenue at Point of Sale or Delivery

Companies can recognize revenue at point of sale if it is also the date of delivery or if the buyer
takes immediate ownership of the goods.

Learning Objectives
Explain how the delivery date affects revenue recognition
Key Takeaways
Key Points
1. The accrual journal entry to record the sale involves a debit to the accounts receivable
account and a credit to sales revenue; if the sale is for cash, debit cash instead. The revenue
earned will be reported as part of sales revenue in the income statement for the current
accounting period.
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 2. When transfer of ownership of goods sold is not immediate and delivery of the goods is
required, the shipping terms of the sale dictate when revenue is recognized. Shipping terms
are typically” FOB Destination” and “FOB Shipping Point”.
3. If a company cannot reasonably estimate the amount of future returns and/or has
extremely high rates of returns on sales, they should recognize revenues only when the
right of return expires.
Key Terms
 Accrual: A charge incurred in one accounting period that has not been paid by the end of it.
 FOB: Stands for “Free on Board” or “Freight on Board”; specifies which party (buyer or
seller) pays for shipment and loading costs, and/or where responsibility for the goods is
transferred.

Recognizing Revenue at Point of Sale or Delivery

Goods sold, especially retail goods, typically earn and recognize revenue at point of sale, which can
also be the date of delivery if the buyer takes immediate ownership of the merchandise purchased.
Since most sales are made using credit rather than cash, the revenue on the sale is still recognized
if collection of payment is reasonably assured.

The accrual journal entry to record the sale involves a debit to the accounts receivable account and
a credit to the sales revenue account; if the sale is for cash, the cash account would be debited
instead. The revenue earned will be reported as part of sales revenue in the income statement for
the current accounting period. Example: A street market seller recognizes revenue when he
relinquishes his merchandise to a buyer and receives payment for the item sold.

Terms of Delivery
When the transfer of ownership of goods sold is not immediate and delivery of the goods is
required, the shipping terms of the sale dictate when revenue is recognized. Shipping terms are
typically “FOB Destination” and “FOB Shipping Point”.

For goods shipped under FOB destination, ownership passes to the buyer when the goods arrive at
the buyer’s receiving dock; at this point, the seller has completed the sales transaction and revenue
has been earned and is recorded.

If the shipping terms are FOB shipping point, ownership passes to the buyer when the goods leave
the seller’s shipping dock, thus the sale of the goods is complete and the seller can recognize the
earned revenue.

Revenue Recognition & Right of Return

If a company cannot reasonably estimate the amount of future returns and/or has extremely high
rates of returns on sales, they should recognize revenues only when the right of return expires.
Those companies that can estimate the number of future returns and have a relatively small return
rate can recognize revenues at the point of sale, but must deduct estimated future returns.

Recognition of Revenue Prior to Delivery

Accrual accounting allows some revenue recognition methods that recognize revenue prior to
delivery or sale of goods.
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Learning Objectives
Distinguish between the percentage of completion method and the completion of production
method of revenue recognition
Key Takeaways
Key Points
1. For most goods that have been sold and are undelivered, the sales transaction is not
complete and revenue on the sale has not been earned. In this case, an accrual entry for
revenue on the sale is not made.
2. The cash method of accounting recognizes revenue and expenses when cash is exchanged.
For a seller using the cash method, if cash is received prior to the delivery of goods, the cash
is recorded as earnings.
3. Under the percentage-of-completion method, if a long-term contract specifies the price and
payment options with transfer of ownership and details the buyer’s and seller’s
expectations, then revenues, costs, and gross profit can be recognized each period based
upon the progress of construction.
4. The completion of production method allows recognizing revenues even if no sale was
made. This applies to natural resources where there is a ready market for these products
with reasonably assured prices, units are interchangeable, and selling and distributing costs
are not significant.

Key Terms
 Conservatism: A risk-averse attitude or approach; for accounting purposes, it relates to
disclosing expenses and losses incurred immediately and delaying the recognition of
revenues and gains until realized.
 Accrual: A charge incurred in one accounting period that has not been paid by the end of it.

Definition of Revenue Recognition

The accounting principle regarding revenue recognition states that revenues are recognized when
they are earned (transfer of value between buyer and seller has occurred) and realized or realizable
(collection is reasonably assured). A transfer of value takes place between a buyer and seller when
the buyer receives goods in accordance to a sales order approved by the buyer and seller and the
seller receives payment or a promise to pay from the buyer for the goods purchased. Revenue
must be realizable. In order words, for sales where cash was not received, the seller should be
confident that the buyer will pay according to the terms of the sale.

Goods in Inventory: Depending on the shipping terms of the sale, a seller may not recognize
revenue on goods sold that are pending delivery.

Methods that Recognize Revenue Prior to Delivery or Sale

 Percentage-of-completion method: if a long-term contract clearly specifies the price and
payment options with transfer of ownership — the buyer is expected to pay the whole
amount and the seller is expected to complete the project — then revenues, expenses, and
gross profit can be recognized each period based upon the progress of construction (that is,
percentage of completion).

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  For example, if during the year, 25% of the building was completed, the builder can
recognize 25% of the expected total profit on the contract. Percentage of completion is
preferred over the completed contract method. However, expected loss should be
recognized fully and immediately due to the conservatism constraint. All revenues,
expenses, losses, and gains resulting from the percentage completed will be reported on
the income statement.
 Completion of production method: 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. All expected revenues and
costs of production related to the units produced will be reported on the income statement.

Recognition of Revenue after Delivery

There are three methods that recognize revenue after delivery has taken place: the installment
sales, cost recovery, and deposit methods.

Learning Objectives
Differentiate between the installment sales method, the cost recover method and the deposit
method to account for recognizing revenue after the delivery of goods
Key Takeaways
Key Points
1. When a sale of goods carries a high uncertainty on collectability, a company must defer the
recognition of revenue until after delivery.
2. The installment sales method recognizes income after a sale or delivery is made; the
revenue recognized is a proportion or the product of the percentage of revenue earned
and cash collected.
3. The cost recovery method is used when there is an extremely high probability of
uncollectable payments. Under this method, no revenue is recognized until cash collections
exceed the seller’s cost of the merchandise sold.
4. The deposit method is used when a company receives cash before transfer of ownership
occurs. Revenue is not recognized when cash is received, because the risks and rewards of
ownership have not transferred to the buyer. Only as the transfer of value takes place is
revenue recognized.
Key Terms
 Deferral: An account where the asset or liability recording cash paid or received is not
realized until a future date (accounting period)
 Liability: An obligation, debt or responsibility owed to someone.

Recognizing Revenue after Delivery of Goods

When a sale of goods transaction carries a high degree of uncertainty regarding collectability, a
company must defer the recognition of revenue. In this situation, revenue is not recognized at
point of sale or delivery. There are three methods that recognize revenue after delivery has taken
place:
Service Delivery: Delivery of goods or service may not be enough to allow for a business to
recognize revenue on a sale if there is doubt that the customer will pay what it owes.

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The installment sales method recognizes income after a sale or delivery is made; the revenue
recognized is a proportion or the product of the percentage of revenue earned and cash
collected. The unearned income is deferred (recorded as a liability) and then recognized to income
when cash is collected.
For example, if a company collected 45% of a product’s sale price, it can recognize 45% of total
revenue on that product. The installment sales method is typically used to account for sales of
consumer durables, retail land sales, and retirement property.

The cost recovery method is used when there is an extremely high probability of uncollectable
payments. Under this method, no revenue is recognized until cash collections exceed the seller’s
cost of the merchandise sold.
For example, if a company sold a machine worth Kshs 10,000 for Kshs 15,000, it can start
recognizing revenue when the buyer has made payments in excess of Kshs 10,000. In other words,
each shilling collected greater than Kshs 10,000 goes towards the seller’s anticipated revenue on
the sale of Kshs 5,000.

The deposit method is used when a company receives cash before transfer of ownership occurs.
Revenue is not recognized when cash is received because the risks and rewards of ownership have
not transferred to the buyer. The seller records the cash deposit as a deferred-revenue, which is
reported as a liability on the balance sheet until the revenue is earned.
For example, sales of magazine subscriptions utilize the deposit method to recognize revenue. A
deferral is recorded when a seller receives a subscriber’s payment on the subscription; cash is
debited and deferred magazine subscriptions (a liability account) is credited. As the delivery of the
magazines take place, a portion of revenue is recognized, and the deferred liability account is
reduced for the amount of the revenue.

Differences between Accrual-Basis and Cash-Basis Accounting

Accrual accounting does not record revenues and expenses based on the exchange of cash, while
the cash-basis method does.
Learning Objectives
Differentiate between accrual and cash basis accounting
Key Takeaways
Key Points
1. Accrual accounting does not consider cash when recording revenue; in most cases, goods
must be transferred to the buyer in order to recognize earnings on the sale. An accrual
journal entry is made to record the revenue on the transferred goods as long as collection
of payment is expected.
2. In accrual accounting, expenses incurred in the same period that revenues are earned are
also accrued for with a journal entry. Same as revenues, the recording of the expense is
unrelated to the payment of cash.
3. For a seller using the cash method, revenue on the sale is not recognized until payment is
collected and expenses are not recorded until cash is paid.
4. The cash model is only acceptable for smaller businesses for which a majority of
transactions occur in cash and the use of credit is minimal.
Key Terms

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  Accrue: To increase, to augment; to come to by way of increase; to arise or spring as a
growth or result; to be added as increase, profit, or damage, especially as the produce of
money lent.
 Liability: An obligation, debt or responsibility owed to someone.

Definition of Accrual Accounting

Under the accrual accounting method, the receipt of cash is not considered when recording
revenue; however, in most cases, goods must be transferred to the buyer in order to recognize
earnings on the sale. An accrual journal entry is made to record the revenue on the transferred
goods even if payment has not been made. If goods are sold and remain undelivered, the sales
transaction is not complete and revenue on the sale has not been earned. In this case, an accrual
entry for revenue on the sale is not made until the goods are delivered or are in transit. Expenses
incurred in the same period in which revenues are earned are also accrued for with a journal entry.
Just like revenues, the recording of the expense is unrelated to the payment of cash. An expense
account is debited and a cash or liability account is credited.

Definition of Cash-Basis Accounting

The cash method of accounting recognizes revenue and expenses when cash is exchanged. For a
seller using the cash method, revenue on the sale is not recognized until payment is collected. Just
like revenues, expenses are recognized and recorded when cash is paid.
The Financial Accounting Standards Board (FASB), which dictates accounting standards for most
companies—especially publicly traded companies—discourages businesses from using the cash
model because revenues and expenses are not properly matched. The cash model is acceptable for
smaller businesses for which a majority of transactions occur in cash and the use of credit is
minimal. For example, a landscape gardener with clients that pay by cash or check could use the
cash method to account for her business’ transactions.

The cash-basis method, unlike the accrual method, relies on the receipt and payment of cash to
recognize revenues and expenses.