Revenue recognition is a fundamental aspect of financial accounting, ensuring that income is reported in the correct period and in compliance with applicable accounting standards, such as IFRS 15 (Revenue from Contracts with Customers) or ASC 606 (Revenue Recognition) under U.S. GAAP.
While revenue is the primary account affected, several other accounts play crucial roles in the recognition process.
Below, we explore the key accounts involved in revenue recognition, detailing their function and importance in financial reporting.
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1. Accounts Receivable (AR)
Nature: Asset
When revenue is recognized but payment has not yet been received, the corresponding entry is typically recorded under Accounts Receivable. This represents the amount due from customers for goods delivered or services rendered.
Journal Entry Example (Accrual Basis)
Debit: Accounts Receivable
Credit: Revenue
Once payment is received, the receivable balance is reduced, and cash is recorded instead.
Cash Collection Entry
Debit: Cash
Credit: Accounts Receivable
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2. Unearned Revenue (Deferred Revenue)
Nature: Liability
In cases where a business receives cash in advance for goods or services that have not yet been delivered, the amount is recorded as Unearned Revenue, a liability account. This reflects the company’s obligation to fulfill the contract in the future.
Journal Entry for Advance Payment Received
Debit: Cash
Credit: Unearned Revenue
Once the performance obligation is met and the revenue can be recognized, the liability is reduced, and revenue is recorded.
Revenue Recognition Entry
Debit: Unearned Revenue
Credit: Revenue
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3. Cost of Goods Sold (COGS) or Cost of Sales
Nature: Expense
Revenue recognition often coincides with recognizing the associated costs. For companies selling physical goods, COGS is recognized when inventory is sold.
Journal Entry for COGS Recognition
Debit: Cost of Goods Sold
Credit: Inventory
In service-based industries, Cost of Sales or Service Costs may be used instead of COGS, representing direct labor or service-related expenses.
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4. Contract Assets (Accrued Revenue or Unbilled Receivables)
Nature: Asset
Under long-term contracts, companies may recognize revenue before issuing invoices. This is recorded as a Contract Asset (also called Accrued Revenue or Unbilled Receivables) and represents revenue earned but not yet billed.
Journal Entry for Revenue Recognition Before Invoicing
Debit: Contract Asset / Accrued Revenue
Credit: Revenue
When the invoice is eventually issued, the contract asset is reclassified to Accounts Receivable.
Journal Entry for Billing the Customer
Debit: Accounts Receivable
Credit: Contract Asset
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5. Sales Discounts and Allowances
Nature: Contra-Revenue
Companies often provide discounts, returns, or allowances to customers. Instead of reducing revenue directly, these adjustments are recorded in separate contra-revenue accounts to track the impact.
Common Contra-Revenue Accounts:
Sales Discounts – Discounts given for early payment (e.g., 2/10, net 30 terms)
Sales Returns – Revenue reversals due to product returns
Sales Allowances – Reductions due to damaged goods or customer complaints
Example: Sales Discount Entry
If a customer takes advantage of a 2% discount on a $1,000 invoice, the entry is:
Debit: Cash $980
Debit: Sales Discounts $20
Credit: Accounts Receivable $1,000
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6. Sales Tax Payable
Nature: Liability
When businesses collect sales tax on behalf of the government, it is recorded as a liability. Sales tax is not revenue but rather an obligation to remit funds to tax authorities.
Journal Entry for Sales Tax Collection
If a company sells a product for $1,000 and applies a 10% sales tax, the entry is:
Debit: Accounts Receivable $1,100
Credit: Revenue $1,000
Credit: Sales Tax Payable $100
When the tax is remitted to the authorities:
Debit: Sales Tax Payable $100
Credit: Cash $100
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7. Contract Liabilities (Performance Obligations Not Yet Satisfied)
Nature: Liability
Contract liabilities are used when a customer has made a payment, but the company has yet to fulfill all its performance obligations under a contract. This is common in:
Subscription-based businesses (e.g., software licenses, magazine subscriptions)
Prepaid services (e.g., annual maintenance contracts)
Journal Entry for Receiving Prepayment
Debit: Cash
Credit: Contract Liability
Once revenue is earned:
Debit: Contract Liability
Credit: Revenue
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8. Deferred Commissions
Nature: Asset
Under IFRS 15 and ASC 606, sales commissions paid on obtaining a contract must be capitalized and amortized over the contract’s duration instead of expensing them immediately. This is recorded as Deferred Commission Expense (an asset).
Journal Entry for Recording Deferred Commissions
Debit: Deferred Commission Expense
Credit: Cash (or Accounts Payable)
As the revenue is recognized, the commission expense is amortized:
Debit: Commission Expense
Credit: Deferred Commission Expense
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Revenue recognition extends beyond just recording income; it involves a variety of asset, liability, and expense accounts that reflect the timing, conditions, and obligations of earning revenue.
Whether dealing with receivables, unearned revenue, contract assets, or cost of sales, maintaining accurate records ensures compliance with accounting standards and provides a clear financial picture of a business.
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