As a business owner, you spend a lot of time trying to increase sales. However, it’s also important to consider when you recognize revenue. All companies need to have a policy for recognizing revenue and apply that policy consistently. This practice allows to you create financial statements that are comparable from one period to the next. Consider these important points regarding revenue recognition.
The matching principle
There are many principles that serve as the framework for accounting. These are the rules of the road that accountants used to produce financial statements. One of those rules is the matching principle.
The matching principle states that revenue earned should be matched with the expenses incurred to produce that revenue. This effort to match revenue with expenses gives the financial statement reader a true picture of company profit. This principle is the basis for the accrual method of accounting. All business should use this method.
Say, for example, that you manufacture jeans. You produce 100 pairs of jeans in February. The material and labor costs are posted to an asset account- inventory. When you sell the jeans in April, you reduce inventory and increase cost of sales (an expense account).
You post your revenue for the jeans sold in April. The result is that both your revenue and your expenses are posted to April. If, for example, each pair of jeans costs $70 and you sell then for $100, you can see the $30 profit per pair in April.
Choosing a revenue recognition method
Every business needs to decide when they will recognize revenue. There are many different points at which you can post revenue to your books. Here are some examples:
- Contract: When the customer signs a contract.
- Shipping: When the product leaves your warehouse and is shipped to the client.
- Invoicing: When your mail, email or hand the customer a bill.
- Payment: You post revenue when you receive payment from the client. This method is used if there is some concern that the customer won’t pay you.
Most of these methods are straightforward. There are some other methods that are more complicated- one of which is covered below.
Another important accounting guideline is the principle of consistency. Whatever method you choose to recognize revenue, stick with the policy. Using the same method allows financial statement readers to compare one year’s financials with another.
If a company changes an accounting method, it can be a red flag. The change will make it harder to compare financial results between years. In fact, the financial impact of the change will normally be a required disclosure. Here’s an example.
Changing your policy
Assume that Acme Jeans recognizes revenue when a customer’s order leaves the shipping dock. When a customer order is received, it normally takes about 5 days for the jeans to be shipped to the customer.
In June, Acme Jeans receives $10,000 in jean orders on June 27th. The jeans are shipped on July 2nd. Acme posts the revenue in July- when the order is shipped.
Now, let’s assume that Acme changes their revenue recognition policy in July. They decide to post revenue when the customer order is received. If the new policy were applied to the June sales activity, the revenue would be different. Specifically, $10,000 in revenue would be posted on June 27th (when the order was received).
If the new policy were applied to past accounting periods, some revenue would be recognized in different periods.
Disclosing the impact
When a company changes an important accounting policy, the impact of that change is normally disclosed in the financial statements. This disclosure explains how the financials would look if the change is applied to past accounting periods.
In this case, Acme might restate revenue for each prior month of the current year. That restatement would recognize revenue when orders are received, rather than when goods are shipped.
As you can see from the example above, the new policy means that more revenue is posted in the last week of the month. Orders received during the last week are immediately posted to revenue. The flip side is that less revenue is posted in the first few days of the new month. When orders are shipped early in the new month, the revenue has already been posted.
The shift pushes revenue into the last week of the prior month.
Some businesses work on long-term projects. If you work on large construction projects, for example, you may work on a project for many months or even several years. A software company may need months to install, test and train people on a new computer system.
These firms may use the percentage of completion method to recognize revenue. In most cases, the contract for a long-term project requires the customer to pay over time. Those payments are based on specific completion points for the project. The completion may be measured by a certain amount of spending, or based on the completion of a specific goal.
Percentage of completion example
Say, for example, that Sturdy Construction is building an apartment complex. They receive payments from the customer at three different points. The client pays Sturdy 30% of the total price when the project is 30% complete. That’s the first payment.
Completion is measured based on total construction spending, and is also measured by the client’s review of the project’s progress. In this case, the 30% completion requires that the building foundation be completed. Assume that Sturdy is also paid at 60% and 100% completion.
Each time Sturdy receives a payment, it can post revenue and profit. However, the profit calculation may change over the period of construction. That’s because the total cost of the project may change over time.
Assume that, at 30% completion, the total revenue of the project is $10,000,000. Total costs are expected to be $8,500,000, which generates a $1,500,000 profit. Here’s the profit recognized at 30% completion:
- ($1,500,000 profit) * (30% completion) = $450,000 profit recognized
Sturdy posts more revenue and profit at 60% completion. Assume that total costs have increased to $9,000,000. The total profit for the job is now only $1,000,000. To post profit at 60% completion, Sturdy needs to first calculate the profit to be recognized, based on 60% completion:
- ($1,000,000 total profit) * (60% completion) = $600,000 profit
The firm then must subtract the profit already recognized:
- ($600,000 profit) – ($450,000 profit already recognized) = $150,000 profit at 60% completion
Sturdy would post profit of $150,000.
Your investors, creditors and industry regulators rely on your financial statements. It’s important to use the accrual method of accounting and the matching principle to post revenue. Once you select a revenue recognition method, stick with it.
If you need to use the percentage of completion method of post revenue, make sure you consider any changes in your total costs, and the profit recognized in prior periods.
All of these steps will help you correctly post revenue and generate reliable financial statements.