- Accrual Basis: revenue recognition is posting income when the company earns it.
- Cash Basis: revenue recognition is recording income when the business receives cash.
How to Master Revenue Recognition
To learn revenue recognition, find out if your business is operating on a Cash Basis or an Accrual Basis. Accountants use one method at a time. Individuals or small businesses use the Cash Basis method of accounting. They use it for income tax purposes. Mid to larger companies use the Accrual Basis Accounting for revenue recognition.
1. Cash Basis
Use this method only if the company earns less than $5 million for the year. As soon as you receive payment from customers, you record the earnings as received. For example, you sell shirts for $50 on April 1, 2015, and receive payment on May 1, 2015. According to GAAP, you would recognize the revenue on May 1, 2015 Debit Cash and credit Sales.
Here is the journal entry on May 1, 2015:
Debit: Cash $50
Credit: Sales $50
2. Accrual Basis
Under the accrual basis, GAAP states you record the entry when you earn money or perform the service. In the above example, you sold shirts in April, but you receive the payment in May. If customers take longer to pay, you would still recognize the income in April Debit Accounts Receivable and credit Sales.
Here is the journal entry dated April 1, 2015:
Debit: Accounts Receivable $50
Credit: Sales $50
In the above example dated April 1, 2015, you record the income before receiving the cash. But, the Cash Basis method records it after the customer sends payment. There is a timing difference between the two styles. You delay Revenue Recognition under the Cash Basis method. However, you recognize revenue right away under the Accrual Basis method.
Under the Accrual Basis, you debit Accounts Receivable. The reason is you have not yet collected the cash. When you receive the money, you need to make an adjusting entry. Please see the journal entry below for January 1, 2016, under “Accrued Revenue.” Small businesses prefer the Cash Basis method—no adjusting entries to make.
Larger companies use the Accrual Basis method because of the auditing process. Auditors can only review financial statements under the Accrual Basis method. One more reason for using the method is for the real profitability of the company. You recognize revenue and expenses in the same period. So, the profit is more accurate.
Timing Difference for Revenue Recognition
1. Accrued Revenue
In this method, you have not yet received the money. This accounting technique requires more than one entry.
For example, you bill someone $100 for consulting service on December 1, 2015. But, the person does not pay you until January 1, 2016. Since you performed the service in 2015, you need an entry to show the earnings. You also need an entry in 2016 to show you have accrued it.
Journal entry for December 1 2015:
Debit: Fees Receivable $100
Credit: Sales $100
Journal entry for January 1, 2016:
Debit: Cash $100
Credit: Fees Receivable $100
In the entry on December 1st, you show you earned money in 2015. But, you received funds in 2016. In 2016, you will have a balance of $100 in the Fees Receivable account. When you deposit the cash, you need to credit Fees Receivable to zero out the account. See the above example.
Here is a more complex example. You have a large project, but you cannot bill for it until the end of the project. In the agreement, you have to show how the case is progressing. Here is the example. A company wants you to consult on a case for $200, but the agreement allows for billing at the end of the case.
Journal entry after finishing 50 percent of the project:
Debit: Accrued Billing $100
Credit: Consulting Fees $100
Journal entry after finishing the 2nd part of the case:
Debit: Consulting Fees $100
Credit: Accrued Billing $100
You need to do an invoice for the entire project, but you have to reverse the first entry shown in the 2nd above example. All accrual gets reversed.
Journal entry to show billing for the full project:
Debit: Fees Receivable $200
Credit: Consulting Fees $200
2. Deferred (Unearned) Revenue
You receive payment in advance for services you offer or goods you have to sell.
Example: You receive $300 in advance for artwork. At the end of the month, you have to show an entry for the fees earned and fees unearned. You did only $100 worth of the work, but you still have to record the entry for the money received.
Journal entry for receiving payment:
Debit: Cash $300
Credit: Deferred Art Fee $300
After receiving payment, you debit Cash and credit Deferred or Unearned Art Fee. The above example shows you have not yet earned the fees.
Journal entry showing a part of the fees received:
Debit: Deferred Art Fee $100
Credit: Art Fees Earned $100
You have done a part of the work. So, you Debit Deferred or Unearned Art Fee and Credit Art Fees Earned. The balance in the Deferred or Unearned Art Fee account is now $200. After you have completed the remaining work, you make a similar entry as in the above example. Debit Deferred or unearned Art fee and Credit Art Fees Earned.
First, find out if the company is using Cash Basis or Accrual Basis Accounting. Second, know the timing difference such as Accrued Revenue and Deferred Revenue. One way to remember how to make the entries is to identify the accounts you are using. When you accrue income, you use an asset and an income account. When you defer income, you use a liability and an income account. Accounts Receivable, Accrued Billing, and Fees Receivable are asset accounts. Deferred or Unearned Art Fee is a liability account. Sales, Consulting Fees, and Art Fees Earned are income accounts.
How do you record your income? Do you recognize revenue on an Accrual Basis or a Cash Basis?