When a company makes revenues from its operations, it must be recorded in the general ledger and then reported on the income statement every reporting period. According to generally accepted accounting principles (GAAP), there are two criteria the company must meet before it can record revenue on its books. The first criterion must be a critical event that triggered the transaction process, and the amount that is to be collected from that transaction is measurable within a certain degree of reliability. Put more simply, a company can recognize revenue from a transaction when the buyer of the company’s good or service agrees to a purchase, and the amount that the customer is going to pay is determined.
For example, a company that is involved in retail will record a revenue when a customer pays for his or her new pair of jeans. The critical event is when the store employee rings the merchandise through the till, and the measurable amount is the price of the goods. The revenue recognition process for the store is complete when the customer pays for the merchandise. If the customer happens to return any merchandise, there will be another transaction on the store’s books that will note the exchange and reduce its revenues accordingly.
If, on the other had, a service contract is awarded to an engineering firm to build a major highway over five years, there is a more complex arrangement made. Depending on the service contract and how the municipality pays for the new highway, the engineering firm could record revenues in a few different ways, but the end result would still be the same. If the municipality pays for the entire project up front, then the engineering firm would record all of the revenue from this service contract at that time. However, if the municipality pays for the highway over the life of the project, a more probable scenario, the company would record the revenues as they are collected from the municipality. The critical event would be the signing of the contract, and the measurable transaction would be when the engineering firm invoices the municipality for services rendered. The invoice will most likely be different from the estimate done earlier due to the unpredictability of operating expenses.
To learn more about finding out how to look for revenue recognition, read Footnotes: Start Reading The Fine Print.