Revenue recognition

Definition

Revenue recognition is an accounting principle that outlines the conditions under which a company can recognise revenue from the sale of goods or services.

What is revenue recognition?

Revenue recognition specifies when and how revenue should be recorded in a company’s financial statements. Proper revenue recognition is crucial for providing an accurate representation of a company’s financial performance. Revenue is typically recognised when it is earned and realisable, meaning that the product or service has been delivered or provided to the customer, and payment is reasonably assured.

It’s a fundamental aspect of accrual basis accounting, which records transactions when they occur rather than when cash changes hands. In some cases, revenue recognition may be tied to the completion of specific performance obligations outlined in a contract with a customer.

When there is uncertainty surrounding the collection of payment, revenue may be recognised only to the extent that it is probable the company will collect. For long-term contracts, revenue recognition may occur over time based on the progress of the project. Companies offering subscription-based services may recognise revenue over the period in which the service is provided. Additionally, companies selling software or licenses may recognise revenue based on specific milestones, delivery, or usage.

Companies are often required to disclose their revenue recognition policies in their financial statements or footnotes. External auditors review a company’s revenue recognition practices to ensure compliance with accounting standards and the accuracy of financial reporting.

Example of revenue recognition

Let’s consider a software company, ABC Software Inc., that sells annual subscriptions to its software service for £1,200 per customer. The company follows the revenue recognition principle where revenue is recognised when it is earned and realised.

ABC Software Inc. sells a subscription to a customer on January 1, 2024, and receives payment upfront for the entire year.

According to the revenue recognition principle, the company recognises revenue over time as the service is provided to the customer. Therefore, ABC Software Inc. would recognise £100 of revenue each month for the subscription, starting from January 1st.

So, on January 31st, ABC Software Inc. would recognise £100 of revenue for the month of January, regardless of whether the customer has used the service or not. This process continues each month until the end of the subscription term.