The revenue recognition principle directs a business to recognise revenue in the period in which it is earned; revenue is not considered earned until a product or service is provided.
This means that revenue is recognised during the period in which the service was rendered or the product was delivered to the customer.
There is no requirement for a correlation between the timing of cash collection and revenue recognition. A customer is not required to pay for a service on the day it was rendered. Even though the customer has not yet paid in full, it is reasonable to assume that he or she will do so in the future. Since the company has rendered the service, it will record the revenue as earned even if payment has not yet been received.
For instance, Lynn Sanders owns Printing Plus, a small printing company. On August 10, she completed a print job for a client. The client did not pay cash for the service at that time; instead, he or she was billed for the service and paid later. When should Lynn record revenue, on August 10 or upon receipt of payment? On August 10, Lynn should record revenue as earned. She rendered the service to the client, and it is reasonable to assume that the client will pay at a later date.
Importance of Revenue Recognition Principle
The Revenue Recognition Principle is important because it ensures that companies accurately reflect their financial performance. This is especially important in periods of rapid growth, when revenue may increase quickly. Without the Revenue Recognition Principle, companies could choose to defer revenue recognition, which would artificially deflate their reported revenue.
The Revenue Recognition Principle is not without its critics, who argue that it can lead to companies overstating their revenue. Critics also argue that the principle can lead to income smoothing, where companies recognize revenue evenly throughout the year even if it is not actually earned evenly.
Despite these criticisms, the Revenue Recognition Principle is generally accepted as a sound accounting principle. It is important to remember that, like all accounting principles, the Revenue Recognition Principle is not a hard and fast rule, but rather a guideline that companies should use in order to ensure that their financial statements accurately reflect their financial performance.