Revenue Recognition

• When you sell goods or services, the money the customer gives you is the revenue that you will record on your income statement. The issue becomes complex when deciding when to recognize the revenue. There are several stages when the revenue could be recognized: at the time the order is placed, at the time the customers walk away with the item or the work is completed or when you received payment for the sale. GAAP requires that revenue is recognized when it has been earned, regardless of whether payment has changed hands.
  
  

Earned Income

• GAAP dictates that, with very few exceptions, revenue is recognized on the income statement when it has been earned. It is considered earned when the risks and rewards of ownership pass to the customer. For example, if the item becomes damaged and the customer has to bear the cost of repair, the risks of ownership have passed. If the item suddenly becomes valuable and the customer can re-sell it and make profit from it, the rewards of ownership have passed. If the customer has not yet paid for the item when revenue has been earned, an accounts receivable entry is generated to offset the revenue. If revenue has been received but has not yet been earned, then a deferred revenue entry is generated to offset the cash received.
  
  

The Matching Principle

• When revenue is earned and recognized, the associated expenses must be recognized in the same period. For example, if a widget was built one year but not sold until the next, not using the matching principle would result in expenses being high in the first year and revenues being high in the second. The costs of manufacturing or purchasing an item must be recognized in the period the revenue is recognized, thereby normalizing income. With goods, the direct expenses of production are kept in the inventory account on the balance sheet until revenue is recognized. For services, the labor and supplies that are directly related to the sale are kept in a work in process account on the balance sheet until revenue is recognized.
  
  

Right of Return

• Often, a company's policies allow a customer to return goods if they are not happy with the purchase. Under GAAP, the fact that customers can do this does not mean that revenue has not been earned. The revenue is still recognized and an allowance for returns is recorded based on the history of such returns. For example, if a company historically has had an average return rate of 2 percent of its sales, it would set up an allowance for that percentage of revenue at year end, by debiting a returns account in the income statement and crediting an allowance for returns account in liabilities on the balance sheet.