Your small business can earn revenue in a variety of ways at a variety of times. Although this flexibility of earning money is great for your small business, it also leads to unique reporting situations. Therefore, you want to understand the following rules related to revenue recognition to ensure your accounting procedures are appropriate.
Cash vs. Accrual
Two methods of accounting exist for revenue recognition: cash basis and accrual basis. The cash basis is simplest, as it stipulates that revenue is recognised when payment is received. Even if you performed work two years ago that was finally paid this month, the revenue is recognised this month. Because this may distort the financial statements, the accrual method is used to report revenue under different rules. These standards create a different set of guidelines revolving around when revenue is reported.
General Recognition Concepts
Revenue recognition rules under the accrual method stem from a few basic concepts. First, revenue should be recorded in the period it is earned and recognisable. Even if payment is not made, revenue is reported when you have a legal claim to cash. The dollar amount must be known or able to be estimated. In addition, you should report revenue in the same period as associated expenses when possible. For example, the accrual method of accounting recognises the cost of goods sold as an expense at the time of sale. This ensures the revenues and expenses for a period tie to the same activity. Finally, you want to approach revenue recognition with conservatism. When a few outcomes exist with the same probability of occurring, a company should report the least favorable outcome to avoid distorting the financial statements.
An accrual for revenue only occurs when a service has been provided or a good has been sold but revenue has not been collected. In this case, the revenue is both earned and recognisable. The journal entry recognises revenue as the credit portion of the entry. Plus, an accounts receivable accompanies all accrued revenue entries. This is because all accrued revenue is yet to be paid, so your small business has a legal claim to receive payment.
In some situations, payment is collected in advance of providing a good or service. For instance, you may agree to supply a company with six months of booking services for $6,000. If the company pays all six months upfront, you have not yet earned revenue because the work has not yet been performed. Under accrual accounting, a liability account is established because you now have an obligation to perform work. Only when the work is performed can the balance in the liability account be adjusted into a revenue account. Be mindful the liability account is typically titled as unearned revenue. Therefore, all $6,000 is initially recorded on the balance sheet as unearned revenue. After completing one month of services, your unearned revenue account, which is a liability, is reduced to $5,000, and your service revenue account should report $1,000.