There are two ways to recognize revenue – the cash method or accrual method. GAAP (Generally Accepted Accounting Principles) requires public companies to report their financials using the accrual accounting method. For non-public companies, business owners may decide between using the cash or accrual methods.
The cash method is very simple. Record revenue when cash is collected. This method does not account for when goods or services were rendered to the customer. The benefit of this is its simplicity as it can be used by any point-of-sale business.
The accrual method is more involved and requires journal entries on the balance sheet account. Revenue is not affected by the timing of payment collections but accounts for when goods or services are rendered to the customer. The benefit of this is the relevancy of financial statements. Using accrual accounting allows business owners to use valued-added information in making strategic decisions for their business. Properly allocating revenue over the course of a contracted agreement best represents how much is earned each term, rather than relying on the date of collection. Business performance is reflected accurately, as the timing of cash movements does not affect performance reports.
According to SAB104, established by the SEC, revenue is recognized and realized when four criteria are met:
- Persuasive evidence of an arrangement exists
- Delivery has occurred or services have been rendered
- The seller’s price to the buyer is fixed or determinable
- Collectability is reasonably assured
Most small businesses operate under what’s called “cash-based accounting”. This is a simple method of recording cash activities coming in and going out.
For example: in January, a retail store sells menswear and the cashier processes the customer’s payment for $10 for one t-shirt. When the clerk accepts $10 from the customer and releases the t-shirt to, a revenue of $10 is realized. Revenue is realized and recognized on the same day. In this example, the retail store met all four criteria of revenue at the time of transaction. While the cash method works well for point-of-sales retail stores, more consideration should take place for businesses with greater complexity in sales and collection differences.
Other businesses that might use the cash method are restaurants, theaters, and salons.
Here is a sample cash method journal entry:
January Cash $10
The accrual method recognizes revenue when earned. The timing of payment collections does not affect the financial presentation of when revenue is realized. Deferred revenue is the recording of revenue when payment is collected before revenue is earned, while accrued revenue is the recording of revenue when payment is collected after revenue is earned.
Deferred revenue is when cash is accepted in advance of earning the revenue. Suppose a software company provides software services that is good for 1 year. Let’s say the menswear business owner purchases and pays for this software service in January for $1,200. Should the software company report $1,200 in January as revenue? No. Although cash was collected, revenue was not earned. It takes the software company 12 months to fully earn the $1,200 collected. The software company can divide the total amount collected in January and then by 12 months to recognize revenue ratably. In this case, the retail store prepaid in advance and the software company will defer revenue until earned.
Other businesses that might use deferred revenue are daycares, professional clubs and organizations, and caterers.
Here is a sample deferred revenue journal entry:
Sold 1-year software license
January Cash $1,200
Unearned revenue $1,200
Adjust unearned revenue to reflect earned portion ($100 per month)
February Unearned revenue $100
December Unearned revenue $100
Accrued revenue involves payment collection after fulfilling sales obligations to a customer. Suppose a consulting firm provides services to the software company. The consultants work in January for 100 hours at $100/hour over the course of the month. The consulting firm bills the software company $10,000 in February and payment is collected in March. When does the consulting company recognize revenue? Since the services that are billed were rendered in January, the consulting firm will recognize revenue in January. Although cash isn’t collected until March, revenue was earned in January.
Other businesses that might use deferred revenue are attorneys, accountants, and physicians.
Here is a sample accrued revenue journal entry:
Accrue unbilled consulting services
January Accounts Receivable $10,000
Record receipt of payment
March Cash $10,000
Accounts Receivable 10,000
Now suppose the software company recognized revenue when cash was collected. They would show $1,200 for January, but $0 for February through December. This would give a false representation of the financial performance over each month, as $100 was earned each month from January through February.
If the consulting firm recognized revenue when cash was collected, then they would show $0 in January and $10,000 in March. This is also misleading, as work was performed and services rendered in January were not captured on the financials. A business owner might see the profit & loss statement and wonder why there were no sales activities in January.
Although the accrual method of accounting is only required for publicly traded companies, businesses should assess whether the benefits of accruing will help add value in the long-run to analyze business performance.