What is Revenue Recognition?
Written By Alexandra Jumper, Director of Accounting, airCFO.
How much revenue did your business really earn this month? How do you record sale transactions under a subscription model or as a professional collecting a retainer? This isn’t always an easy question to answer.
Revenue is the income generated by the sale of goods and services related to a company’s primary operations. What determines when revenue should be recognized? Especially when customer payments are collected before or after the work or service is provided. For example, a contractor may charge clients for services upfront, or an app may charge a one-time fee for 12 months of access to its users. So when and how is revenue recognized?
In order to have accurate financial statements, you need to make sure that your business is recognizing revenue in the appropriate period. So, how do you know if you’re recognizing revenue appropriately? First and foremost, it’s time to learn the basics of revenue recognition.
What Should I Know About Revenue Recognition?
Revenue recognition is an accounting principle that outlines the specific conditions for when revenue is recognized and how it is recorded.
Your business’s accounting method determines how transactions are recorded. If your business uses cash accounting, your earnings are recognized when cash is received (i.e., when funds hit your bank account). With accrual accounting, you recognize revenue when it’s earned under the revenue recognition principle.
Different methods of recognizing revenue include:
- Completed contract: Revenue and expenses are recorded once the contract is complete.
- Sales-basis: Revenue is recognized at the time of sale, which is when goods or services are transferred to the customer.
- Percentage of completion: Revenue and expenses in long-term contracts are recognized as a percentage of the work completed during that period.
- Cost recoverability: Revenue is not recognized until expenses sustained to complete the project have been recouped.
- Installment: Revenue is recorded when an installment payment is received.
No matter the accounting principle or method of revenue recognition, it’s important that your books show accurate profit and loss margins. Standard revenue recognition guidelines are set in place to ensure a lateral comparison can be made between companies when reviewing line items on income statements. This is why the U.S. GAAP, administered by the Financial Accounting Standards Board (FASB), has rules for when and how to recognize revenue as well as how to report it on income statements.
Outside of the U.S., the International Financial Reporting Standards (IFRS) is administered by the International Accounting Standards Board (IASB) and has a set of broader guidelines for businesses that expand beyond U.S. borders. Investors or other entities outside of the organization may require that your financial statements adhere to GAAP or IFRS guidelines.
Why and When Should Founders Understand and Care About It?
You should always care about revenue recognition! Your financial statements provide key insights about the business and tell a story about the financial wellbeing of your company. Revenue recognition is not only important from a regulatory standpoint, but it’s also vital to internal operations, investors, financial institutions, advisory boards, and shareholders. During due diligence, investors look at revenue to assess a company’s performance and prospects, which is why it’s vital to maintain transparency and build strong relationships with your investors.
What Are the Five Steps to Recognizing Revenue?
In 2014, FASB announced a new standard ASC 606. This went into effect for publicly-traded companies in 2017 and private companies in January of 2019. FASB stated that “the new guidance is to establish principles to report useful information to users of financial statements about the nature, amount, timing, and uncertainty of revenue from contracts with customers.” The standard describes the principles an entity must apply to recognize and measure revenue. The principles in ASC 606 are applied using a five-step process:
- Identify the contract with your customer – The contracts must contain the following criteria: approval of contract, identification of each party’s rights & the payment terms, commercial substance and probability that the entity will collect substantially all of the consideration for exchange of the goods/services.
- Specify performance obligations outlined in the contract – Separate each good or service and identify them in the contract. For example, if you have a subscription business model that delivers flowers but also offers to deliver and set up floral arrangements at weddings, you need to make that distinction when recognizing revenue. Don’t forget to mention discounts, refunds, credits, incentives, etc.
- Determine the transaction price – The contract must clearly state what the customer will be charged for all goods and services being delivered.
- Match the price to the performance obligations in the contract – The price for each individual good or service must be broken down. If there’s no exact price, an estimation needs to be provided.
- Recognize revenue as you deliver each good or service – Recognize revenue after each good or service is delivered, separated, and priced.
Recognizing Revenue for SaaS Businesses
For SaaS or subscription-based services, revenue recognition can require a few additional steps. In most cases, revenue is deferred and isn’t recognized immediately. When does a performance obligation (step 2) count as being fulfilled for SaaS businesses? There are five criteria for recognizing billings as revenue:
- Risks and rewards have been transferred from the seller to the buyer
- The seller has no control over the sold goods
- The collection of payment is reasonably assured
- The amount of revenue can be reasonably measured
- The costs of earning the revenue can be reasonable measured
The new accounting standards state that a company must account for a promise to provide a customer with the right to access as a performance obligation by the company satisfied over time. On the other hand, a company can promise to provide a customer with the right to use the company’s software at a point in time. SaaS businesses have different performance obligations and contract types and revenue must be recognized accordingly.
Understanding the Importance of Revenue Recognition
To maintain accurate financial statements, you need to properly recognize your business’s revenue depending on your business model. This allows you to give factual profit and loss statements, which is necessary when looking for investors or financing.
Before trying to tackle the complexities of revenue recognition, it’s best to consult a professional. airCFO can help you understand how your business should be recognizing revenue to stay compliant and provide transparency to customers, financial institutions, investors, and shareholders.
Find out how we can help you by scheduling a discovery call now
Author Note: Alex serves as the Director of Accounting at airCFO. She is a CPA with extensive experience advising startups, and previously worked in the Big 4 and private equity space.