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 principles (GAAP) offer guidance as to when a business should recognize income.
Recognized vs Realized Accounting
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 property and other assets. Income also includes claims on cash, such as customer sales made on credit.
While the definition of income is the same from business to business, companies generally have a choice about they bring the income into their books. Businesses that use the accrual method of accounting "recognize" revenue at different times than those that "realize" income using the cash method of accounting.
Accrual Method Accounting
Under the accrual method of accounting, a business recognizes revenue when as soon as a transaction takes place. 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.
Read More: How to Calculate Accounting Accrual Basis
Cash Method Accounting
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.
For example, if a manufacturer ships out goods worth $8,000 on 30-day payment terms, the company does not recognize the $8,000 until it has received payment for that amount. Businesses may prefer to use the cash method of accounting because it is less complex than the accrual method.
Read More: Accounts Payable Cash Basis Vs. Accrual Basis
GAAP Revenue Recognition
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. On the other hand, 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.
Read More: Operating Earnings vs. GAAP
Sue-Lynn Carty has over five years experience as both a freelance writer and editor, and her work has appeared on the websites Work.com and LoveToKnow. Carty holds a Bachelor of Arts degree in business administration, with an emphasis on financial management, from Davenport University.