Realized vs. Recognized Income

In general, a business realizes income, or revenue, when it receives cash or when it receives a claim to cash. Whether a business realizes or recognizes its earnings as revenue depends on whether it uses the accrual method or the cash method of accounting. The generally accepted accounting principals (GAAP) offers guidance as to when a business should recognize income.

Income includes all of the money a business earns from its normal business activities and other cash-generating activities such as earnings on investments or proceeds from the sale of assets. Income also includes claims on cash, such as customer sales made on credit. Businesses that use the accrual method of accounting recognize revenue at different times than those that use the cash method of accounting.

Under the accrual method of accounting, a business recognizes revenue both when it earns it and when it receives it. What this means is that even if the business has not received payment for goods sold or services rendered, it still recognizes the revenue it earned from those goods and services. For instance, a business that cleans carpets but only invoices its customers once per month recognizes the income earned from the carpet cleaning services when they are rendered, even though it has not received payment from its customers.

Under the cash method of accounting, businesses do not recognize revenue until it actually receives payment for goods and services rendered. For a claim on cash such as a sale made on credit, the business does not recognize revenue from the sale until it receives payment from the customer. Businesses may prefer to use the cash method of accounting because it is less complex than the accrual method.

GAAP rules for revenue recognition are that revenue should be recognized when the revenue is both earned and received (realized). Additionally, revenue should not be recognized until a specific and significant transaction occurs. Revenue should not be recognized from sales made on credit unless the company has a valid and reasonable assurance that it will receive payment. For example, a bank with a loan contract can realistically expect to receive payment from its customers, therefore, it can reasonably recognize the revenue from the loan. A business that sells a product with a promise to pay from the customer with no formal contract may not be able to reasonably expect payment for the product. Therefore, the business cannot reasonably recognize revenue from the sale.