When Is Revenue Earned? Key Principles Explained

Revenue represents the total money a business generates from its primary activities, such as selling goods or providing services, before any expenses are subtracted. It is often referred to as the “top line” because of its position on a company’s income statement. Accurately determining when revenue is earned is important for a business’s financial reporting, allowing stakeholders like investors and lenders to assess performance and growth.

Earning revenue is not always the same as receiving cash. For example, a business might provide a service today but receive payment for it next month. Proper revenue recognition prevents financial misreporting and supports compliance with accounting standards.

Cash Versus Accrual Accounting

Businesses use one of two primary accounting methods: cash basis or accrual basis. The choice of method significantly impacts when revenue is recorded. Understanding these differences is key to knowing when revenue is earned.

Under cash basis accounting, revenue is recognized only when cash is received, regardless of when the goods or services were delivered. Similarly, expenses are recorded only when cash is paid out. This method is often simpler and can be used by smaller businesses, as it directly reflects cash inflows and outflows.

In contrast, accrual basis accounting recognizes revenue when it is earned, irrespective of when cash is received or paid. This means that if a service is performed or a product is delivered, the revenue is recorded even if the customer has not yet paid. Expenses are also recorded when they are incurred, not necessarily when they are paid.

Accrual accounting is preferred for financial reporting by most businesses, especially larger businesses. It provides a more accurate picture of a company’s financial performance over a specific period. It aligns revenues with the expenses incurred to generate them, offering better insight into profitability. This method is required for public companies under Generally Accepted Accounting Principles (GAAP) in the U.S., ensuring consistency and comparability in financial statements.

Key Principles for Earning Revenue

Under accrual accounting, revenue is considered earned when a company satisfies its performance obligations by transferring promised goods or services to a customer. It focuses on the transfer of control of the goods or services to the customer.

The process of recognizing revenue involves five steps:
Identify the contract with a customer.
Identify the distinct performance obligations within that contract, which are the specific promises to deliver goods or services.
Determine the transaction price, which is the amount of consideration the business expects to receive.
Allocate the transaction price to each performance obligation if the contract contains multiple obligations, based on its standalone selling price.
Recognize revenue when, or as, the business satisfies each performance obligation by transferring control of the good or service to the customer.

Earning Revenue from Goods Sales

When a business sells physical goods, revenue is earned when control of the good transfers from the seller to the buyer. This means the customer has gained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.

Several indicators suggest that control of a good has been transferred to the customer:
The seller has a present right to payment for the asset.
The customer has legal title to the asset.
The customer has physical possession of the asset.
The customer has assumed the significant risks and rewards of ownership, such as responsibility for damage.
The customer has accepted the asset.

For instance, in a retail store, revenue for a product is recognized at the point of sale because all these indicators are met immediately.

Earning Revenue from Service Provision

For businesses providing services, revenue is earned as the service is performed or completed, aligning with the transfer of control of the service to the customer. This can occur at a specific point in time or over a period, depending on the nature of the service agreement.

Services performed at a point in time are those where the customer receives the full benefit of the service upon completion. An example includes a car repair where revenue is earned once the repair is finished and the customer can use the vehicle. Similarly, a one-time consulting report would have its revenue recognized when the report is delivered and the client gains its full benefit.

Other services are performed over a period of time, meaning the customer simultaneously receives and consumes the benefits as the service is delivered. Examples include subscriptions, long-term maintenance contracts, or ongoing consulting engagements. For these services, revenue is recognized proportionally over the service period, such as monthly for a gym membership or as work progresses on a large project. This method reflects the continuous transfer of benefit to the customer.