The revenue recognition principle under US GAAP (Generally Accepted Accounting Principles) provides a clear framework for recording revenue across all businesses. The standardized approach has a variety of benefits, and the principle is relied upon by various stakeholders.
Like all accounting policies, the aim is to provide an approach to financial reporting that results in clear, relevant, and accurate information.
In this post, we will cover what the revenue recognition principle is, how revenue is recognized on financial statements, as well as the importance of the principle.
What Is A Revenue Recognition Principle?
Revenue recognition is an accounting principle that details how a business should recognize revenue on its books. The policy itself can vary depending on the overall accounting policy that the business has in place.
In general, there are two primary ways of financial reporting – cash basis and accrual basis. Under the cash basis of accounting the revenue recognition principle requires that revenue is recognized when cash is received. Under the accrual method of accounting the revenue recognition principle outlines that it should be recorded in the period that it was earned, not received.
Revenue recognition principles are one of the foundational principles defined in US GAAP. This is because the principle unifies how businesses across sectors and industries report revenue, enhancing the reliability of financial statements.
Under the accrual method of accounting, the revenue recognition principle of US GAAP covers how to report various types of revenue, including contracts, services, and other specialized forms of revenue.
How Is Revenue Recognized On Financial Statements?
How revenue is recognized depends on the overall accounting policy that a business has adopted. Any public organization operating in the US must report under the accrual method of accounting, as defined by US GAAP.
Under the accrual method, the revenue recognition principle requires that revenue is always reported in the period that it is earned, not necessarily when cash is received. The distinction between earned and received is very important. Under the cash method of accounting, revenue is recognized when it is received.
The difference between the two is important to understand. Under the accrual method, sales, become an important revenue metric as it shows the true sales made in the period even though cash might not have been received for those sales.
Additionally, by reporting revenue in the period that it is earned it eliminates the impact of extraordinary events that might otherwise provide an inaccurate reflection of the true revenue of a business.
Because businesses might have multiple revenue streams, the financial statements often break out the various streams and show revenue from each product line. Regardless of presentation, the revenue recognition principle requires any revenue stream to be reflected in the period that it was earned.
The Importance Of Revenue Recognition Principles
Financial analysts prefer that businesses operate with accounting policies that are standardized. This allows them to easily compare various businesses across multiple sectors and competitors. Therefore, it is important that US GAAP makes an appropriate determination on how revenue should be recognized, but also that businesses should strive to maintain a standard approach over the long run.
One of the many benefits of standardizing revenue is that it allows both internal and external analysts to identify trends in revenue, like high-demand seasons. Managers use this information to assist in the development of annual budgets and forecasts.
Revenue Recognition Principle and FP&A
Many accounting principles make sense in the context of financial planning and analysis (FP&A). This is because many of the principles aim to provide consistent, accurate, and relevant financial reporting.
For example, during the FP&A process, managers review past activity for trends in demand or expenses. The seasonality of demand drives many businesses and one of the benefits of having adopted the accrual method of accounting is that it requires revenue and expenses to be reported in the period they were earned or incurred.
In doing this it provides clear, consistent, and relevant reporting that can be relied upon across periods of time. This creates a framework that allows financial models, like those used in the FP&A process, to be consistent and more accurate.
The standardization provided by this framework allows for a wide variety of users to utilize the information presented in the financial statements for a wide variety of reasons.