Mar 8, 2017
The only accounting method accepted by general accepting accounting principles (GAAP) is the accrual basis accounting method, which requires you to recognize revenue when it is earned. Revenue is considered earned when the revenue process is substantially complete, or when one has delivered on a service or product.
This means you can recognize revenue before receiving payment from the customer. On the other hand, you may also be paid before earning the revenue, and this would cause you to have unearned revenue on your books.
Unearned revenue is a prepaid revenue account and it should be classified as a current liability on the balance sheet because you have not earned the payment by delivering on the service or product. If you did notdeal with unearned revenue in this manner, and instead recognized it all at once, revenues would initially be overstated, and then understated for the additional periods in which the revenues should have been recognized. This would result in an inconsistency with the matching principles of accounting because revenues are recognized at once, while related expenses are not recognized until later periods.
While the only accounting method accepted by GAAP is accrual basis, there are several acceptable methods for recognizing revenue. Acceptable methods include the installment method, cost recovery method and industry specific methods.
The installment method is when a seller/company providing a service or product is willing to take periodic payments for delivery of a service or product. In such a method, revenue is recognized in the periods the seller receives the payments.
Another method, the cost recovery method, is used when a seller/company providing a service or product(s) isn’t reasonably assured to recover the cost of providing the service or product(s). As such, a seller/company only recognizes revenue once it receives payment of at least the cost of goods sold.
Finally, industry specific methods for recognizing revenues vary. As the method’s name implies, GAAP will find acceptable certain methods depending on the unique nature of the industry in question. For example, for industries involved in building and providing a product that may take years to create, a revenue recognition approach appropriate for their industry would be percentage-of-completion method, which allows companies to show and recognize revenue even though the service or product is not “substantially complete.”