Every time a business makes a sale or signs a customer up for a subscription, this means there’s money coming through the door. That is great news for profitability and growth, but earning revenue also comes from responsibility—namely, that every dollar you earn needs to be recognized correctly on the balance sheet.
Put simply, revenue recognition defines when and how revenue is recognized in financial statements to accurately reflect the transfer of goods or services to customers. Proper revenue recognition not only provides an in-depth view of financial performance, but also enables informed decision-making about budgeting, investments, and expansion.
In this blog, we dive into the key principles of revenue recognition, compliance with industry standards like ASOC 606, and best practices for implementing new standards—without the headaches.
TL;DR
- Revenue recognition is the process of defining when and how revenue is recorded in financial statements to accurately reflect the transfer of goods or services to customers.
- ASC 606 introduces a five-step model to simplify and streamline revenue recognition, covering contract identification, performance obligations, transaction price determination, allocation, and recognition timing.
- Best practices for revenue recognition include establishing clear policies and procedures tailored to the business, providing regular training for finance teams, and using technology solutions like Stax Bill to simplify recognition management.
Principles of Revenue Recognition
The purpose of revenue recognition is to guide merchants through how to recognize or record different streams of revenue at their business. The revenue recognition principle gives clarity on when and how this occurs.
In accrual basis accounting, the core principle is that revenue must be recognized in accounts receivable by a business when it is earned, rather than when they receive payment for the good or service. Revenue can be considered as “earned” by a company when the following criteria are met.
- There is clear evidence of a financial arrangement.
- The product or service delivery is completed.
- The price to the buyer is fixed or measurable.
- The funds are reasonably collectible.
This criteria covers scenarios where promised goods or services are received by the customer upfront but payment isn’t due until a later date, such as a subscription service or monthly invoicing schedule.
In the past, the revenue recognition process has been confusing and inconsistent regarding when revenue should be recognized within the accounting period. For this reason, U.S. GAAP standards(Generally Accepted Accounting Principles) introduced the new revenue standard ASC 606 to set the new revenue recognition standard that allows for better comparability of income statements between business entities.
The Five-Step Model Introduced by ASC 606
To simplify and streamline revenue recognition, ASC 606 provides a five-step process for determining how and when revenue needs are recognized:
1. Identify the contract with a customer
There must be an enforceable contract in place that lays out rights and responsibilities for both the business and the customer. A contract can be verbal, written, or implied, according to the terms and conditions laid out in your product or service agreement. A contract exists when the following criteria are met:
- The business and the customer are dedicated to fulfilling their functions i.e. meeting payment terms and delivering goods as promised.
- The rights of each party are clearly identified regarding the transfer of rewards of ownership and meeting payment terms.
- There must be a high likelihood of the transaction price being collected and fulfilled.
2. Identify the performance obligations in the contract
Performance obligations refer to promises by the business to transfer goods or services to the customer. If goods/services are being delivered as individual offerings, the business needs to define these as separate performance obligations. An obligation is regarded as separate if the customer can use it either on its own or as part of a wider service offering, and the transfer happens independently from the rest of the performance obligations in the contract.
3. Determine the transaction price
The transaction price refers to the amount of consideration that a company receives in exchange for transferring certain goods or services to the customer. However, this may fluctuate according to the applications of variable consideration, which covers any discounts, rebates, refunds, warranties, or incentives applied by the business. This process requires businesses to consider all possible variable considerations and assign a probability to each outcome to calculate the final transaction price.
4. Allocate the transaction price to the performance obligations
When there is more than one performance obligation outlined in the contract, businesses must determine how much of the total transaction price should be assigned to each separate performance obligation. This makes it possible to recognize revenue as and when each of those performance obligations is fulfilled.
This is fairly straightforward when each obligation comes with a standalone selling price (in the case of add-on services). However, selling prices may need to be adjusted to take into account the variable considerations outlined in step three.
5. Recognize revenue when (or as) the entity satisfies a performance obligation
To recognize revenue, the business must determine when the promised goods or services have been transferred into the customer’s ownership. Depending on the nature of the performance obligation, revenue will either be recognized at the moment of transfer or gradually over a period of time.
If multiple performance obligations are satisfied at different points in time, revenue must be recognized accordingly. For subscription and SaaS businesses, it is common for revenue to be recognized over a period of time, as the product/service is being received and consumed for the entirety of the subscription.
Accrual vs. Cash Basis Accounting
Accrual accounting is the key revenue recognition principle behind ASC 606. It requires an amount of revenue to be recognized at the point of earning, rather than payment. This is the opposite of cash-basis accounting, which only recognizes revenue at the point that funds are received by the business. Accrual accounting also uses the matching principle to closely track expenses. The matching principle aligns revenue earnings with the expenses incurred by the business to generate that revenue, making it possible to build a picture of real-time financial performance.
Common Challenges in Revenue Recognition
Multiple deliverables in one contract
Many customer contracts contain more than one performance obligation, meaning these obligations may be completed within different billing periods. When this occurs under ASC 606, businesses must recognize revenue based on the transaction value of the separate performance obligations as they are completed, rather than once the contract is finished. This means balance sheets will contain a mix of earned and deferred revenue, which can complicate understanding cash flow.
This mixed revenue allocation is seen most frequently with product bundles or service add-ons, which is very common in SaaS business models. To handle this, businesses need a clear understanding of the separate performance obligations involved in each contract and calculate the selling prices of each to allocate the transaction price accurately.
Variable considerations and constraints
Variable considerations, as outlined in step three of ASC 606, refer to any activities that affect the transaction price. This includes any discounts, rebates, refunds, warranties, or incentives being applied that affect the amount of revenue the business earns.
IFRS 15: Variable Consideration Constraint covers how businesses should treat variable considerations to prevent them from overstating their revenue. This requires sound judgment and experience with previous sales to make accurate predictions on what is payable.
Managing licensing and royalties
Because royalty payments are ongoing and sporadic after the piece of work is completed, determining both the timing and amount of revenue to be recognized is complex. Determining revenue recognition in this scenario requires a deep understanding of licensing agreements and knowing when control over the licensed product is sold or transferred between parties.
Long-term contracts
When a contract spans a long period of time, this complicates revenue recognition because businesses need to allocate and record revenue correctly across multiple reporting periods. This happens often in construction projects, legal cases, and software products that involve multi-year contracts.
Usually, this is handled using the percentage of completion method, which recognizes revenue according to what percentage of the total contract has been fulfilled within that accounting period. To use this revenue recognition practice, a business needs to be able to reasonably estimate both expenses and how much of a project is going to be completed within each timeframe.
How-Tos: Best Practices for Revenue Recognition
Establishing clear policies and procedures
Creating and documenting revenue recognition policies that are tailored to your business helps to ensure consistency and compliance across different departments. These procedures should always align with the principles outlined in accounting standards your business complies with (such as ASC 606). Transparency should be given to relevant stakeholders so they understand how your financial statements are being presented.
Regular training and updates for finance teams
As demonstrated with the introduction of ASC 606, revenue recognition standards are continuously evolving. It’s important that your financial teams receive regular training sessions to keep them informed about changes in international financial reporting standards. This ensures that personnel feel confident about implementing the latest practices.
Using technology and software solutions
Implementing software that is tailored to the latest revenue recognition standards can make revenue recognition much more efficient and streamlined for your business. A solution like Stax Bill uses automation to create a compliant revenue recognition schedule for your products, reducing the risk of errors and ensuring that any adjustments to performance obligations are synced and tracked.
Periodic internal reviews and audits
Conducting regular internal reviews of your company’s revenue recognition processes helps to identify issues or weaknesses before they go on to cause problems for your business. It’s important to ensure that every step of your SOP is being followed, and if not, whether there are any points of friction that are making compliance more difficult for your finance team. Internal audits help to provide reassurance and accountability to management and stakeholders that your revenue recognition practices are aligned with internationally recognized accounting standards.
Implementation Tips
Transitioning to the new revenue recognition standards
When adopting a new revenue recognition standard such as ASC 606, businesses can choose between a retroactive or prospective approach to transitioning.
A retroactive approach requires businesses to rework past financial statements as though this new standard has always been applied. This offers a more comparable view of financial statements before and up to the point ASC 606 came into effect. Alternatively, businesses can take a prospective approach. This means adopting the new standard from a specific date and not restating previous statements.
Both approaches have their pros and cons. Retroactive adoption is time-consuming to execute, and may not be suitable for small businesses with less accounting resources. While the prospective approach is much simpler, it doesn’t provide as much insight into the impact of the new standards on financial reporting.
Importance of documentation and record-keeping
It’s important to document all steps taken by your business during the implementation process, so you can look back on them later during SOP refreshes to understand decision-making. Given the possibility of audits, all documentation relating to revenue recognition and reporting needs to be stored centrally for easy retrieval.
Collaboration between sales, legal, and finance teams
Implementing new standards should never happen in a vacuum. Revenue recognition affects more than just accounting teams, with Legal and Sales teams in particular involved in actioning many of the changes brought about by ASC 606. Host workshops to make sure these teams understand the implications of areas like contract structure and how earned versus deferred revenue needs to be expressed.
Considering industry-specific nuances
The new revenue recognition standards affect some industries more than others, so it’s important to understand industry-specific considerations related to revenue recognition. For example, SaaS companies that offer digital subscriptions face more complex revenue recognition processes under ASC 606, because there are a lot of variable considerations such as plan upgrades, downgrades, and cancellations that affect the final transaction price. Your implementation process needs to address these complexities and understand how they affect revenue recognition.
Use the right tools to stay on top of revenue recognition principles
There are a variety of tools that you can leverage to assist with revenue recognition and complying with standards like ASC 606. Stax Bill offers a fully ASC 606-compliant subscription management solution that enables merchants to effortlessly organize subscriptions into component services, building a compliant revenue recognition schedule.
As one of the most important metrics for financial success, the proper recognition of revenue is crucial for maintaining accurate, transparent financial reporting. Keeping pace with fresh accounting standards like ASC 606, ensures that businesses are using best practices for revenue recognition while also fostering trust among investors and stakeholders.
As revenue standards continually evolve and update, it’s essential for businesses to stay adaptable and embrace a culture of continuous learning. Staying informed about changes in accounting practices and technology solutions that streamline the process enables companies to make data-driven decisions and respond appropriately to challenges.
FAQs about the revenue recognition principle
Q: What is the revenue recognition principle?
The revenue recognition principle is a fundamental accounting concept that dictates how and when revenue should be recorded in the financial statements. According to this principle, revenue is recognized when it is earned and realizable, regardless of when the cash is actually received. This concept is a key part of accrual accounting and differs from cash accounting, where revenue is recorded only when cash is received.
Q: What is the importance of revenue recognition?
If a company cannot consistently accurately recognize revenue, it’s impossible to measure financial performance. This affects a business’s ability to apply for loans, attract investment, and stay accountable to stakeholders, especially for public companies with more stringent reporting standards.
Q: How does ASC 606 impact businesses?
The purpose of ASC 606 as set out by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) is to simplify revenue recognition and create a more consistent global standard. It requires companies to recognize revenue when the promised goods or services are delivered, and according to the amount out of the promised whole that has been delivered in that accounting period.
Q: What are the key differences between accrual and cash basis accounting in terms of revenue recognition?
Accrual accounting requires businesses to recognize at the time it’s earned, rather than when payment is received. Cash-basis accounting, on the other hand, only recognizes revenue when payment is made by the customer.
