Basically, the principle means revenues are recognized when they are realized or earned, irrespective of when the cash comes in.
Recognizing the revenue means recording the amount of ‘consideration’ as ‘earned’ revenue in a company’s financial statements. It’s the process by which companies identify ‘when to’ and ‘how much’ (expected) revenue to be recorded as earned, or recognized, revenue. Revenue is earned when a company has delivered the product(s) and/or performed the services, and met all criteria of revenue recognition as outlined by the GAAP guidance.
New GAAP Guidelines
A customer may pre-pay or post-pay a company for a product and/or service or pay at the point of sale. However, the company recognizes the payment (pre-payment, post-payment or point of sale payment) at the point in time when the company satisfies the terms of the sales contract and the ‘value’ of the deal is delivered or transferred to the customer.
As an example, let’s say your company builds widgets. This company receives $100 of consideration (or pre-payment) from a customer for a yet-to-be-built widget. This $100 pre-payment goes into your company’s bank account. Your company hasn’t delivered the widget to the customer yet, so the firm hasn’t ‘earned’ the consideration, or revenue, from the sale of the widget. Using accrual accounting (in which timing for the recognition of income doesn’t coincide with timing of receipt and payment of cash), the company must account for that $100 pre-payment as deferred revenue.
Now, in building this widget and shipping it to the customer, your company has costs equating to $50, which are accounted for under deferred expenses.
At the point in time when the company satisfies the terms of the sales order, which in this example happens when the company delivers the widget to the customer, the company may recognize the pre-payment of $100 as recognized, or earned, revenue and may also recognize the $50 in deferred expenses as actual, or realized, expenses.
Now, imagine this company is selling millions of widgets and has to keep track of all that revenue. Or that the company also sells “widget installation” services and a “widget warranty.” There may be rebates as rewards for certain customer behaviors. All these factors, and more, can affect the pricing and timing of your revenue. It becomes so complicated, so quickly, that spreadsheet-based processes quickly become the weak link in a very important chain. Who wants to take that chance with their revenue?