When to Recognize Revenue
Revenue recognition is one of the most important concepts in accounting. Deciding when to record revenue and expenses can have a huge impact on the financial statements. Incorrectly recording revenue that has not been earned can inflate profits and give potential investors or lenders incorrect information about the company’s future profitability.
Revenue should be recorded when it is earned, essentially when the work is done. For some businesses, this is fairly simple. When I complete a tax return for a client, I have earned revenue. When a retailer sells a product, revenue is earned. It does not matter when payment is received; the work is completed and therefore the revenue should be recorded. Payments do not affect the recognition of revenue.
When deciding how to record transactions involving revenue, there are two important questions you should ask yourself:
- Did the company do the work?
- Did the company get paid?
The following chart should help guide you through the process of determining if revenue should be recognized.
Notice the first question is regarding the work. This is the most important factor. Once we have determined it work has been done, then we can look at payment information to determine what the debit should be in the entry.
Let’s look at some examples.
K’s Bounce House Adventures rents bounce houses to individuals and corporations for parties. K’s has the following transactions during the month of February. Record the necessary journal entries.
Feb 2 – K’s agrees to provide a bounce house for a corporate function on February 10 for $300. The companies sign a contract stating that payment will be made on the date of the function.
Feb 4 – K’s provides a bounce house for a birthday party and gets paid at the end of the party, $250.
Feb 5 – K’s provides two bounce houses for a town picnic, $700. K’s must bill the town and will receive payment within 30 days.
Feb 7 – K’s signs a contract to provide a bounce house for a birthday party on Feb 20 for $350. The contract requires the customer to pay 50% of the balance today and the rest the day of the party.
Feb 10 – K’s provides the bounce house for the contract signed on Feb 2 and is paid.
Feb 13 – K’s provides a bounce house for a function booked in January. The customer paid the entire amount of the contract, $275, when the function was booked.
Feb 20 – K’s provides the bounce house for the contract signed on Feb 7 and is paid the remaining balance.
Feb 25 – K’s receives the payment from the town event on Feb 5.
For each of the transactions, ask yourself the two questions above. The solutions are listed below with explanations. Try working through the transactions before looking at the solutions. Take notes on the transactions you had trouble identifying. Usually there is a pattern. Find your weaknesses and work on them. Write your own transactions for those types of entries.
Click here for the solutions to the transactions.
Basic Journal Entries, Part 1
Basic Journal Entries, Part 2
What are adjusting journal entries?
The matching principle states expenses must be matched with the revenue generated during the period. The purpose of adjusting entries is to ensure that all revenue and expenses from the period are recorded. Many adjusting entries deal with balances from the balance sheet, typically assets and liabilities, that must be adjusted. In addition to ensuring that all revenue and expenses are recorded, we are also making sure that all asset and liability accounts have the proper balances. Adjusting entries are dated for the last day of the period.
When analyzing adjusting entry transactions involving assets and liabilities, remember that you are recording the change in the balance, not the new balance in the account. Ask yourself “what must I do to the account to get the adjusting balance?”
As a business goes through the normal day-to-day operations, many transactions are recorded. When work is done and the company is paid, revenue is recorded. Revenue is also recorded when invoices (accounts receivable) are created. Expenses are recorded when bills (accounts payable) are received. If the company has already recorded all those things, then what could possibly be left to do? You would be surprised!
NOTE: Cash should never appear in an adjusting entry. Most adjusting entries are done after year end and backdated to the end of the year. When cash is spent, the transactions are recorded immediately. With electronic banking, we can instantly check cash transactions. There is no reason why a business shouldn’t know about transactions affecting its cash accounts. Cash is never an account in an adjusting entry.
If a business has done work for a client but has not yet created an invoice, there is unrecorded revenue that must be recorded. Maybe the business just hasn’t gotten around to completing the invoice yet, or maybe the work is partially done but not completely finished. This entry looks exactly like an entry to record work that has been completed but have not yet been paid for.
On December 31, KLI Video Production had completed $3,000 worth of work for clients which has not yet been billed.
Another type of unrecorded revenue deals with work the business was paid for before the work was completed (unearned revenue) which was completed by the end of the period. Transactions of this type can be written two different ways. We could be told how much revenue has been earned or we could be told the remaining balance in unearned revenue. Let’s look at how these transactions could be written so you can see the differences and identify which method to use.
Unearned revenue has an unadjusted balance of $4,000. An analysis of the account shows that $2,500 of the balance has been earned.
When looking at transactions like this one, we need to determine what we are being given. You want to ask yourself if the transaction is giving you the amount of the adjustment (revenue or expense to be recorded) or the adjusted (correct) balance in the asset or liability account. T-accounts are really helpful when doing adjusting entries because you can visualize what is happening. Here is the T-Account for unearned revenue.
We are told the account has an unadjusted balance of $4,000. Unearned revenue is a liability account and therefore the normal balance is a credit. We are told that $2,500 has been earned. Is that the new balance in the account? No, the $2,500 is the amount we need to remove from the account because it is no longer unearned. So if $2,500 is not the balance, then what is the balance? If the business has earned $2,500 of the $4,000, then the new balance is $1,500.
Now we can see the beginning balance and the ending balance in the T-account. Now, we have to determine how to get there. If we have a $4,000 credit balance and then have a $1,500 credit balance, the balance decreased by $2,500. How do we decrease an account with a credit balance? We debit the account. The $2,500 was given in the transaction, but now we know what to do with it. If you can predict what the balance should be in the account, you can do a T-account to make sure your entry will actually do what you predicted.
The credit in the entry is fees earned (revenue) because we were told that $2,500 had been earned. When you see earned, you should always think revenue unless the transaction states the money has not yet been earned. That statement should make you think of unearned revenue because it has not been earned.
The company had an unadjusted balance in unearned revenue of $4,000. An analysis of the account shows $1,500 is still unearned.
This transaction is worded a bit differently than the last. This transaction tells you what the ending balance in the account should be. Using a T-account in this scenario is a smart idea.
Notice, this example is exactly the same as Example #2. In order to get the balance from $4,000 credit to $1,500 credit, we need to debit unearned revenue $2,500.
Make sure to watch the wording in all adjusting entry transactions to ensure you understand what information you have.
Typically, when we are looking for unrecorded expenses, we look to the balance sheet. There are two types of unrecorded expenses: those that are related to assets that have been used up or need to be adjusted and those related to unrecorded liabilities.
Assets and Expenses
The definition of an asset is something the company owns or has the right to which it can use to generate revenue. When we were recorded journal entries, we recorded transactions to various asset accounts that when used up, will generate an expense. Some of those accounts were supplies, prepaid expenses and long-term asset accounts, like equipment and buildings.
Supplies are initially recorded as an asset, but they get used up over time. Rather than record an entry every time a ream of paper or a bag of mulch is removed from storage, we do an adjusting entry at the end of the period to record the amount of supplies that have been used up. Recording an entry every time something is removed from the stockroom or garage would violate the cost-benefit constraint. At the end of the period, the company counts up what is left for supplies. The difference between the balance in the account (unadjusted) and the amount that is left (adjusted) is the value used in the journal entry.
The balance in the supplies account at the end of the year was $5,600. A count of supplies shows that $1,400 worth of supplies are still on hand.
What does this transaction tell us? The unadjusted supplies balance is $5,600 but the adjusted balance should be $1,400. The transaction does not tell us the amount of the adjustment. That is something we will need to figure out. You may want to draw up a quick T-account to visualize the transaction.
To decrease the account balance, which is a debit balance, we need to credit the account. How much will we need to credit the account? What amount will bring the balance from $5,600 to $1,400? The difference is $4,200. So we need to credit the supplies account $4,200.
Where did the supplies go? They were used it. We call this supplies expense. Now we can write the journal entry.
Use the same methodology when doing entries involving prepaid expenses. Draw a T-account to help visualize what is happening.
Long-term assets and Expenses
When a company purchases a long-term asset, such as a vehicle to use in its business, we record the entire value of the purchase as an asset. That vehicle is used to generate revenue so shouldn’t that vehicle somehow be expensed? Yes, it should be. We call the expensing of a long-term asset depreciation. Do not confuse depreciation in accounting with how the term is used outside of accounting. Typically, we think of depreciation as a decline in market value. For example, I have heard it said many time that when you purchase a new car, it depreciates or loses 20% of its value when you drive off the lot. Depreciation in accounting has nothing to do with market value. Depreciation represents the using up of an asset to generate revenue.
The cost principle states that we must record assets at cost. In order to maintain that principle, when we record depreciation expense (which is a debit in the journal entry), we do not credit the asset directly. Instead we will use a contra account. A contra account is an account linked to another account but which has a normal balance opposite to the account it is linked to. A contra asset account would be linked to a specific asset account but would have a credit balance. For the vehicle described above, we would have a contra asset account called accumulated depreciation. This account would be linked to the vehicles account and would have a credit balance.
Some companies have one accumulated depreciation account used for all long-term assets and others have a separate accumulated depreciation account for each long-term asset account. In the next example, we will assume there is one accumulated depreciation account.
The company calculates that the current year depreciation is $12,000.
As with all adjusting entries, we need to determine if we are being given an account balance (asset or liability) or the amount of the expense. In this case, as with all depreciation entries, we are given the amount of the expense. Therefore, there is nothing to calculate here. No T-account is needed.
For more information about long-term assets and depreciation, see the posts on long-term assets and calculating depreciation.
Adjusting Entries Involving Liabilities
Some adjusting entries involve expenses that have not yet been paid for nor has the obligation been recorded. However, in these cases an expense has been generated. Examples include unrecorded bills and unpaid wages, interest, and taxes. This is not an exhaustive list but it does cover most of the transactions you will see. These entries require the recording of an expense and a liability.
The company received a bill for December’s utilities on January 5. The bill was for $235.
Although the bill was received in January, the utilities were used in December to generate revenue in December. The matching principle tells us that we must record the utilities expense in December.
The company pays its employees every two weeks. On December 31, the employees had worked four days for which they had not been paid. The amount due to the employees was $4,300.
Are you thinking matching principle here? Our employees help us generate revenue. The wages that we pay them must be matched to the revenue they are creating. Therefore, the $4,300 must be recorded in December. The wages have not been paid so we must show a liability. The liability used in this case will be wages payable.
Note: Accounts payable should only be used for routine bills (utilities, supply and inventory purchases). Other short-term payables should be named based on the expense they are related to. That is why wages payable was used in this case.
The company has a long-term note payable with Ginormic National Bank. As of December 31, $670 of interest had accrued on the loan but had not yet been paid.
Why do we have to record this? First, the interest is an expense for December even though it has not yet been paid. Second, to be accurate in our financial statements, the balance owed to the bank on December 31 includes not only the balance on the loan but also the unpaid interest. If we contact Ginormic National Bank to payoff the loan on December 31, we would need to pay the principal owed plus the $670 of interest. The interest is considered a separate payable and should not be added to the note payable.
The company estimates its profit to be $42,000 for the year and is in a 35% tax bracket.
When reading this transaction, it doesn’t even sound like something we would need to record. It just sounds like a statement, but the matching principle should set off an alarm. Why are we paying income taxes? The company had a profit for the year of $42,000. Income taxes are an expense of doing business. Should the expense fall in the year that is completed or the year we are currently in? The expense is related to the year that is completed and, therefore, must be recorded as an adjusting entry.
To figure out how much to record for taxes, we need to calculate 35% of the profit, which would be $14,700 ($42,000 x 0.35). Now we can record the entry.
Things to Remember
Treat adjusting entries just like you would treat normal entries. Use these steps when completing adjusting journal entries.
- Read the transaction to determine what is going on. Is an entry required?
- Identify the accounts you will use in your entry. Remember, cash is never used in adjusting entries!
- Determine the amount. Did the transaction give you the amount to use or do you need to calculate it? T-accounts are helpful here.
- Determine which account(s) to debit and which account(s) to credit.