What it means
Under accrual accounting, revenue is recorded when it is earned rather than when the money arrives. A consultant who finishes a project in March records revenue in March, even if the client pays in May.
The main accounting frameworks use a five-step model. A business identifies the contract, identifies the promises it must deliver, sets the price, allocates the price to each promise, and recognises revenue as each promise is satisfied.
Some revenue is recognised at a single point in time, such as when a customer takes delivery of a product. Other revenue is recognised over time, such as a software subscription or a long building contract, in line with the progress made.
The contract terms decide which pattern applies. When cash arrives before the work is done, the business records deferred revenue, which is a liability (an obligation) rather than income.
It moves into revenue gradually as the service is delivered. A growing deferred revenue balance is often a good sign, because it shows customers have paid for work still to come.
Recognised revenue matters because it feeds profit, tax, bonuses, loan covenants and company valuations. Because the timing is a matter of judgement, auditors examine it closely, and aggressive recognition is a classic source of restated accounts.
Nuances include variable payments such as bonuses and penalties, product returns, and contracts with several deliverables. In each case, the business must estimate the amount it expects to keep and avoid recording more than it is likely to earn.
In practice
Real-world examples
Example 1
A gym sells 12-month memberships for $600 each, paid up front. It recognises $50 per member each month. In a month when 2,000 memberships are active, recognised revenue is 2,000 x 50 = $100,000, whatever cash arrives that month. The rest of the cash received sits in deferred revenue.
Example 2
A construction firm agrees to build a warehouse for $2,000,000 and judges the job to be 40% complete by the end of the quarter. It recognises 2,000,000 x 0.40 = $800,000 for the quarter to date. The client's payments may follow a different schedule.
Example 3
An online retailer ships a $120 order and allows returns within 30 days. Based on past patterns, it expects 5% of orders to come back. It records revenue net of an allowance for the expected returns, not the full amount, so on $1,000,000 of shipments it holds back 1,000,000 x 0.05 = $50,000.
Think of it
Imagine a gym membership paid upfront for the year. The gym does not earn all that money the moment you swipe your card; they earn it bit by bit each month as you continue to use their facilities.
Formula
Calculation
Recognised revenue to date = Total contract price x Percentage of obligation satisfied
For a subscription: Monthly revenue = Total price / Number of months
Suppose a customer pays $36,000 on 1 January for a 12-month software subscription. Monthly revenue is 36,000 / 12 = $3,000. After four months, recognised revenue is 3,000 x 4 = $12,000. The remaining deferred revenue is 36,000 - 12,000 = $24,000, which stays on the balance sheet as a liability until the service is delivered.Case study
Seen in the real world
Meridian Learning is an illustrative, fictional online-course company that sold three-year access plans for $1,800 each. In one busy quarter, it sold 5,000 plans and reported $9,000,000 of revenue in its sales dashboard.
The finance controller pointed out that access was delivered over 36 months. Only 1/36 of each plan was earned per month, so recognised revenue for the quarter was about 5,000 x 1,800 x 3 / 36 = $750,000, assuming all sales were made at the start of the quarter.
The company changed its dashboard to show bookings, recognised revenue and deferred revenue side by side. In this illustrative story, the board stopped planning spending as if all the cash were income. The finance team also explained the three numbers in a one-page guide for managers. After that, conversations about targets and bonuses used the same definitions across sales, finance and operations, and the monthly reconciliation took far less time.
Watch out
Common mistakes
- Recording revenue when cash is received, when accrual accounting requires it to be recorded when earned.
- Treating bookings or invoices as recognised revenue, even though the work may not be delivered and the customer could still cancel.
- Recognising the whole value of a long contract at signing, when it should follow delivery of the product or service over the life of the contract.
Questions
People also ask
What is the difference between revenue and cash received?
Revenue is income earned in the period, while cash received is simply money that has reached the bank, which can be earlier or later. Profit and cash flow statements therefore rarely match.
What happens to cash received in advance?
It is recorded as deferred revenue (a liability) and moves to revenue as the product or service is delivered.
Who decides when revenue is recognised?
Management applies the accounting rules to each contract, and auditors review those judgements. The finance team should document the reasoning for any unusual contract.