When Should You Record Revenue for a Business?

Revenue represents the income a business generates from its primary activities, such as selling goods or providing services. Correct revenue recording provides a clear picture of a company’s financial performance, affecting financial statements and how a business is valued. It also has implications for tax obligations, as taxable income is directly tied to recognized revenue.

Understanding Revenue Recognition Principles

Revenue recognition is guided by fundamental principles that determine when a business can record income. One principle states that revenue is recognized when it is “earned.” This means the business has substantially completed its obligations to the customer, such as delivering a product or performing a service. For example, if a software company receives an upfront payment for an annual maintenance fee, it will recognize this payment as deferred revenue and only recognize it as actual revenue over the period the service is provided.

Another principle is that revenue must be “realized or realizable.” This means cash or claims to cash, like accounts receivable, have been received or are reasonably assured of being collected. If a seller ships goods to a customer on credit and bills them for $2,000, the seller realizes the entire $2,000 as soon as the shipment is completed because there are no additional earning activities to complete. Delayed payment is a financing issue, not a revenue issue.

These principles are applied differently depending on the accounting method a business uses. Cash basis accounting recognizes revenue only when cash is received and expenses when they are paid. For instance, if a consulting business completes a project in December but receives payment in January, under cash basis, the income is recorded in January. This method is simpler and often used by smaller businesses that do not carry inventory.

Accrual basis accounting, which is the standard for most businesses, recognizes revenue when it is earned, regardless of when cash is received. Using the same consulting example, under accrual basis, the income would be recorded in December when the service was completed, even if payment arrives in January. This method provides a more complete view of a company’s financial health, including money owed to the business (accounts receivable) and money the business owes (accounts payable). The Internal Revenue Service (IRS) requires certain businesses to use the accrual method based on their gross receipts.

The Core Steps for Recognizing Revenue

Businesses follow steps to determine when revenue should be recorded, applying the principles of when revenue is earned and realized. The first step involves identifying the contract with a customer. This means agreeing on the terms, including payment and delivery of goods or services. Contracts can be written or implied through verbal agreements.

The next step is to identify the performance obligations within that contract. These are the specific goods or services the business promised to deliver to the customer. For example, if a contract includes selling an airplane, providing one year of engine maintenance, and initial pilot training, each of these would be considered a separate performance obligation.

After identifying the obligations, the business must determine the transaction price. This is the amount of money the business expects to receive in exchange for transferring the promised goods or services. The sales price of products or services is usually predetermined.

If a contract involves multiple performance obligations, the transaction price must be allocated among them. This allocation is based on the standalone selling prices of each distinct good or service. This ensures that each part of the contract is recognized appropriately as it is fulfilled.

The final step is to recognize revenue when, or as, the entity satisfies a performance obligation. Revenue is recognized when control of the promised good or service is transferred to the customer. This can occur at a specific point in time, such as when goods are delivered, or over a period, such as providing ongoing services.

Applying Revenue Recognition to Different Business Activities

The principles and core steps of revenue recognition apply across various business models, with the timing of recognition adapting to the nature of the transaction. For sales of goods, revenue is recognized when physical products are shipped or delivered to the customer. At this point, the customer gains control of the goods, meaning they have the risks and rewards of ownership. For example, if a customer orders a product online, revenue is recognized when the item leaves the warehouse and is transferred to the customer.

For service revenue, recognition depends on whether the service is performed at a point in time or over a period. If a service is completed at a specific point, such as a one-time repair, revenue is recognized upon completion of the service. When services are performed over time, like a cleaning service provided weekly, revenue is recognized proportionally as the service is delivered over the agreed-upon period.

Subscription or recurring revenue models, common in software-as-a-service (SaaS) or memberships, involve recognizing revenue over the subscription period. If a customer pays $240 for an annual software subscription, the business would recognize $20 in revenue each month over the twelve-month period. Even if the payment is received upfront, the revenue is deferred and recognized incrementally as the service is provided.

Long-term contracts, such as construction projects or custom software development, involve significant timeframes and multiple performance obligations. For these contracts, revenue is recognized over time using methods like the percentage-of-completion method. This approach recognizes revenue proportionally based on the progress of the project. This ensures that revenue is matched with the expenses incurred throughout the project’s duration.