Understanding the Revenue Recognition Principle
The revenue recognition principle helps you better understand the ways through which your startup can generate revenue, which in turn helps you communicate with your accountants and bookkeepers.
If you own and operate a startup, you know that the whole of your operation centers on your ability to generate and collect on revenue. While there are practical measures designed to make this process simpler, there’s also a degree of theory that goes into the crafting of a lucrative business.
This is where the revenue recognition principle comes into play. This concept helps you better understand the ways through which your startup can generate revenue, which in turn helps you communicate with your accountants and bookkeepers. It’s all a part of staying on top of your financial responsibilities, as well as your responsibility to potential investors.
But what, precisely, is the revenue recognition principle? And what’s the point? Let’s break this theory down to its bare essentials so you can better understand how it interacts with your startup.
What Is The Revenue Recognition Principle?
The revenue recognition principle details the conditions through which your business is able to recognize the revenue that it takes in. What does this mean, though?
Generally, after a sale or a transaction, you can consider that money as revenue, but there are exceptions. There are specific points at which the value from a transaction can be recorded or recognized as revenue, according to both the IFRS and the U.S. GAAP. Understanding those points can help you more accurately report your revenue on your taxes and in your startup’s books.
When Can Revenue Be Recognized?
What are the points, then, at which revenue can be recognized? According to the GAAP, these points are:
- When the “risks and rewards of ownership” have been exchanged between the seller, you, and your buyer, leaving the buyer in control of the exchange.
- When you, as the seller of a good or service, no longer control the product you’ve sold.
- When it’s reasonably assured that you will collect payment from a good or service.
- When your revenue can be measured.
- When the financial cost of earning your revenue can be measured.
As you may have guessed, the wording which details each of these points reflects the legal importance of the financial exchange between a seller and a buyer. Your startup must adhere to these points and their wording if you want to be able to legally report your revenue.
These points are also numbered here because, for many startups, they arrive in the aforementioned order. Points 1 and 2 are referred to as Performative Points, or parts of revenue’s Performance. This is because points 1 and 2 require action on the part of both the seller and the buyer – action which will result in the seller expecting compensation for a good or service.
Point 3 is known as the Collectability point. At this point, you as the seller must be certain that you will receive compensation for the service you’ve rendered unto the buyer.
Points 4 and 5 come after you’ve received compensation from your buyer. You must match your expenses to your collected compensation and vice versa according to the accounting guidelines of the matching principle.
The Steps of Revenue Recognition
The principle of revenue recognition can get more complicated, so it’s important to be informed. The previous points are simply the conditions that must be met for compensation to be considered revenue, but that’s not the end of it. Once those conditions have been met, you can move forward in the process of recognizing your revenue. For that, you need the following:
You form a contract with a buyer upon presenting them with a good or service. To form this contract, you must meet the following conditions:
- Both parties must consensually agree to the contract, be it written, verbal, or implied
- The contract which you, the seller, for with the buyer must have commercial substance
- The point at which goods or services are transferred from you, the seller, to the buyer must be readily identifiable
- Terms of payment must be readily identifiable
- It must be probable that you, the seller, will collect your compensation
Once the basis of your contract with your buyer has been formed, you must identify the obligations to which your contract binds you. These obligations are performative, more often than not.
For these performance obligations to be distinct from one another, they must fulfill the following conditions
- The buyer must benefit from the good or service outside of your startup
- The good or service must be a separate item in the aforementioned contract
Determining Your Transaction Price
Now for something easier. Once you’ve established your contract and obligatory performances, you can set a price for the goods or services you’re selling. Normally, this price is fixed, though it does not violate your contract to negotiate your price in return for additional obligations. That negotiation process, or the allocation of a transaction price, comes into play when more than one performance obligation is on the table.
Recognizing Revenue As It Relates to Performance
Finally, with all of the contract details hammered out – normally in a situation that takes less than 30 seconds – you’ll be able to take the aforementioned recognition points into account. More often than not, you’re able to recognize income as revenue once your buyer has taken possession of the goods you’ve offered them. Services, in turn, can have their revenue recognized once that service has been rendered.
The theory behind revenue recognition details a lot of practices new startups take for granted. Without a solid understanding of the revenue recognition principle, you’ll have a tough time defending your financials in front of an investor, or you won’t be able to close a debt round, or you may not actually have as much revenue as you think you did. This can hurt your business in a lot of ways, including by negatively impacting your employees and even impacting your ability to keep the lights on. With a good grounding in the basics though, you’re well equipped to build a financial foundation from which you can grow.