Here are the two traditional revenue recognition criteria that must both be satisfied before revenue can be recognized:
- The seller has to do something, the work, and
- The buyer has to do something, pay or provide a valid promise to pay.
Is it okay to recognize revenue before the cash is collected? Well yes, as long as the buyer has provided a valid promise to pay. This is just an ordinary credit sale. The customer buys now and, hopefully, pays later.
When does a sale get reported in the books?
Let’s think about hypothetical Well Inc., a company that makes and sells industrial equipment. And let’s look at a sequence of seven events in order with respect to the sale of one piece of equipment by Well Inc. to a customer for $100,000. These events occur over the course of almost a year.
1) The Well Inc. salesperson thinks about the customer.
2) the salesperson negotiates with the customer and eventually receives a formal order.
3) the construction of the equipment is finished.
4) the equipment is loaded on a truck and shipped to the customer.
5) the equipment arrives at the customer’s place of business.
6) the equipment is installed, tested, and formally accepted by the customer.
7) six months after delivery, the customer pays Well Inc. cash for the price of the equipment, $100,000. The accounting issue is simple.
When should Well Inc. report this $100,000 sale in its accounting records? The reporting of the sale is called Revenue Recognition.
The recognition of revenue begins the process of measuring income. Once revenue has been recognized then expenses can be matched. In addition, without recognizing revenue, a company can’t hope to report any profit. Accordingly, company accountants are typically under great pressure to recognize revenue, report revenue in the books as soon as possible.
So, let’s consider each one of these events in terms of whether that is the right time for Well Inc. to report the $100,000 sale, to recognize the revenue.
1) the Well Inc. salesperson thinks about the customer. Well, nice try Well Inc., but no one thinks that the $100,000 sale should be reported just based on thinking about the customer. No one except the salesperson, who would love to report the sale and get the commission now.
2) the salesperson negotiates with the customer and eventually receives a formal order. Interestingly, this is certainly an important event. In fact, if the order were big enough, Well Inc. would put out a press release announcing the signing of the contract. Boeing and Airbus, the large aircraft manufacturers, issue such press releases all the time. However, if you carefully read those press releases, they make clear that the airplanes themselves, are not going to be made and delivered for many years. Signing the order is an important event, a cause for celebration, but probably not the right time to recognize the $100,000 sale because Well Inc. hasn’t really done anything yet.
3) the construction of the equipment is finished. Well, we’re getting closer, but the construction of the equipment can occur even in the complete absence of a customer. Companies could then report sales just by making things and stacking them in a warehouse, so this probably isn’t it.
4) the equipment is loaded on a truck and shipped to the customer. Now things start to get interesting, things are happening. In fact, this might be the time to report the sale depending on the shipment terms. Sometimes the terms of shipment state that legal ownership and responsibility for the equipment transfers from the seller to the buyer at the time of shipment. For those of you interested in technical terms, this is called shipment FOB, shipping point. However, this might not always be the right time for revenue recognition.
5) the equipment arrives at the customer’s place of business. The customer now has the equipment, and depending on the shipment terms, has finally taken legal ownership. Transfer of ownership at the time of arrival is called FOB destination. In the absence of special circumstances, it makes sense to recognize that sale no later than right here.
6) the equipment is installed, tested, and formally accepted by the customer. Occasionally, a sales contract specifically states that the customer has no obligation to take ownership of the product being sold, the equipment in this case until the customer has formally signed off on the satisfaction of substantial inspection and testing conditions. If there are such conditions, then Well Inc. isn’t done doing what she has promised to do until the customer has formally accepted the equipment.
7) six months after delivery, the customer pays Well Inc. cash for the price of the equipment. Up until this point, we have forgotten to even mention the cash. And here, is an important point: in a normal business transaction, it is assumed that the customer will eventually pay the cash.
Accordingly, the revenue is reported in connection with the economic transfer of the rights to the equipment. The collection of the cash is a mere settling of accounts. Remember: revenue is not a cash flow measure. Revenue is a measure of economic activity.
If you decide to sell parts of your goods and/or services on credit, make sure to read our list of tips to optimize your accounts receivables.
If your company trades goods and/or services on credit, you might often find yourself chasing unpaid invoices, even if you’ve used all tools at your disposal to manage credit risk. While you might be successful in getting your money back a few times, sometimes you’ll have to ask a professional for help and hire a debt collection agency. Here are 6 things you need to know before you hire a debt collection agency.