How Revenue Recognition Accounting Works

The principles of revenue recognition accounting are necessary for corporations to accurately describe their financial standing. Identifying when a company has earned income is not necessarily simple with many factors to take into consideration. Working out exactly when earnings can be attributed as income is subject to application of rules and good judgement.

Accountants and managers are constantly identifying when the income is earned, when they have made a profit. Have the preliminary functions been done. Does a signed agreement exist with the client, or has a confirmed order been received. Is the customer aware of the price and can the customer pay for the transaction. And when has the contract been fulfilled. Are the goods now held by the customer, or are they to be delivered. Has any services committed to been done.

Ensuring revenue is recorded in the correct time frame is the basis of accrual accounting. This has rules to split revenues over multiple accounting periods, or defer recording of income to ensure earnings are recorded in the time frame they relate to. Mistiming corporate earnings can be detrimental to investors and suppliers to a company.

Working out when the goods have been delivered or services performed is not always simple. It is easy to determine if a valid contract has been agreed, if price has been agreed and that the bill can be paid. Getting the work completed, the product in the hands of the customer, and ensuring what has been promised is delivered is the hard part.

The normal expectancy is that both the supplier and customer will record the transaction in the same accounting period. When this does not happen, then the question of revenue allocation needs to be looked at. Examples of this is paying insurance annually in advance, or shipping goods out overnight on the last day of the month.

For example, an insurance agent gets paid full commission on the initial signing of a contract with the customer, but is subject to pay back of commissions if the customer cancels the policy inside of two years. While the agent has been paid, the value of the sale is dependent on a future event, namely that the customer pays premiums for two years. There is a case to argue that income, or some of the income, has not been earned until the future event has been fulfilled.

Another situation occurs in construction where long term projects are common. Progress claims are submitted by contractors to clients and these are agreed on for part of the works done and paid. When a progress claim is paid, then that part of the contract is determined to have been complete and the customer taken ownership, even thought he full job is not complete. The rule of thumb on this is could another person or company take over a partially finished job and complete the works. Because the answer is yes, income can be recognized during the works.

We inherently trust accountants and managers to follow the generally accepted accounting principles for revenue recognition accounting. This is supported by independent auditors who verify that a corporation has followed the rules and presented their accounts correctly. This is important in not paying too much tax, ensuring finance providers make informed investments in the and that shareholders have correct information.

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