Accounting / Bookkeeping Basics: Revenue Recognition Principle

Revenue Recognition Principle
The revenue recognition principle is used in accrual accounting (the type of accounting that records both expenses and revenue when they occur, not when the cash is actually received).
That is what the revenue recognition principle stands for: a business should record their revenue not when they receive the cash (or pay the cash), but when they are actually acknowledged.
Basically, the moment you send an invoice to a client, you already record it on your balance sheets. For instance, if you have provided marketing services to a client and they were worth $2,000, you will send the invoice at the end of February.
However, the client will not pay you for another three months, which means that the revenue will be cashed in only at the end of May - but it will be considered as “realized” at the end of January, when you delivered the services and sent the invoice. In accrual accounting, you will record the invoice on your balance sheets as if it already “happened” - and this is based on the revenue recognition principle.

In some ways, the revenue recognition principle is similar to the matching principle. The main similarity between the two is related to the fact that every activity should be recorded when it happens. The main difference, however, is that the revenue accounting principle only refers to revenue and the accounting period that they should be recorded in. At the same time, the matching  principle talks about the expenses and the correct accounting period that they should be recorded in.
Both concepts are used in accrual accounting and lie at its very foundation. They are also basic generally accepted accounting principles, which makes them quite important especially for businesses who plan on going public, because it allows for a standardized method of bookkeeping that will not keep potential investors and creditors in the dark.
It is worth noting here that cash accounting is used as well. However, it tends to be less popular with businesses who want to go public, precisely because records might be unreliable (the cash might take some time to enter the flow, and thus, the records might be altered).

When is the Revenue Recognized?
There are some rules to guide accountants in knowing when to recognize the revenue (and thus, when to enter it in their books). In general, there are five steps that have to be followed for revenue to be considered as “recognized” and ready to be entered on the balance sheets:
1. There has to be some sort of link with a contractor. Most often, this is a written contract that has clearly defined their financial compensation. Sometimes, an oral arrangement can be used as well.
2.The performance obligations in the contract (written or verbal) have been noted. Put simply, a performance obligation is a point the contractor has to meet as per the contract they have signed or agreed with. So, for instance, if you own a marketing company and you make 2,000 visits to your website a performance obligation, you have to deliver - and once that happens, you can take note of it.
3. The price of the transaction has to be determined. This means that, as a provider of services or goods, you have to determine the transaction price in your contract. This will become the amount of consideration your client has to pay in exchange for the services or goods you have delivered. Keep in mind that any kind of money collected on behalf of third parties (e.g. a copywriter your marketing firm has contracted for this specific project) should not be included in the transaction price.
4. The price of the transaction and the performance obligations should be matched through a process called “allocation process”. Basically, you can allocate the price to the performance obligation that reflects the aforementioned amount of consideration you, as a seller, expect to receive when the performance obligation is satisfied. When determining this allocation, you have to first estimate the selling price of the services or goods you have delivered from  the moment the contract started.
5 Recognize the revenue when the obligations are fulfilled (i.e. when the services or goods you are selling have been transferred to the customer). When the transfer is completed (the customer is in possession of the services or goods), the revenue can be recognized.

6 Exceptions from the Revenue Recognition Principle
While the revenue recognition principle is commonly used in accrual accounting, there are some exceptions as well. The main situations when the revenue recognition principle should not be used include the following:
In some cases, manufacturing businesses may have to recognize the revenue during the production process (as opposed to recognizing it when the products are sold). This is especially true in the case of long-term contractors (such as those working in defense or construction, for example). In these cases, the revenue will be realized (and then cashed in) at various stages in the process (e.g. when the foundation of a new building is laid, when the first floor is up, etc.).
1. In some cases, manufacturing companies will recognize the revenue once the process is done, but before the actual sale is done. For instance, this is commonly used in agriculture and mining - and the main reason this method is used in these industries is because  the goods are good to go to market and sold as soon as they are mined, plucked, or harvested.
2. When accrual accounting is not used and when companies do their accounting on a cash basis, the revenue recognition principle is not followed (because, as explained before, it goes in contradiction with the type of accounting used). Companies that work based on installment sales are more commonly inclined to this accounting method.