Revenue recognition is known as an accounting principle that every business owner accepts in the market. When a company offers a product or service to the customer and measures the amount, revenue recognition is easily recognized.
In 2014, Accounting Standard Codification 606 was released. The Financial Accounting Standard Board (FASB) released revenue recognition. It was considered part of the Generally Accepted Accounting Principles. This consists of the direction of how companies should recognize revenue.
Later, the International Accounting Standard Board released another guidance identical to the previous one. This also includes content explaining ‘when revenue can be considered earned’.
Here, we will unwrap every detail of what revenue recognition is. So, if you are a business owner, then this blog will be a highly knowledgeable platform for you.
What Does Revenue Recognition Term Mean?
Revenue recognition is defined as an accounting principle that guides when a company should recognize revenue. It instructs companies to count earned money as revenue from sales on the company’s financial statements.
Key Points About Revenue Recognition –
- Revenue recognition standards may change due to geographical location, the company’s accounting method, and other factors.
- It is essential to include accurate revenue recognition because it impacts the integrity of a company’s financial reporting.
- The FASB released ASC 606, and it standardized the revenue recognition process.
- IASB issued a similar IFRS 15 while collaborating with FASB.
Why Is Revenue Recognition so Important?
Based on GAAP accounting, public companies report their financial statements. Revenue recognition is a principle of accounting that states revenue recognition should be at the time of earning. It provides a concise depiction of a company’s financial overview and status. It also disables the company’s cook-the-book approach.
Revenue recognition serves as the foundation for business decision-making. It assists companies in determining resource allocation, opportunities and risks, and pricing strategies. Following official guidelines enhances the credibility of the company.
While mitigating potential risks associated with misreporting revenue, revenue recognition ensures compliance with legal and regulatory requirements.
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Different Types of Revenue Recognition
E-commerce With Further Fulfillment
Usually, customers pay before receiving the goods when making an e-commerce purchase. However, revenue recognition does not depend on the receiving payment. Recognizing revenue at the time of product delivery is always a better practice as per ASC 606.
Digital Goods
Downloading digital goods like movies, songs, and e-books is nowadays a common activity. As the user downloads them, revenue is recognized on the spot. However, digital goods are often confused with streaming or software services. However, they are the same when it comes to their utilization. Digital goods are one-time purchases, while software or streaming services are recurring.
Digital Subscriptions
Revenue recognition can be made when the customer signs up for a digital subscription or SaaS. Companies can do revenue recognition throughout the service period in a linear form. Additionally, it must consider account cancellation and upgrades.
Metered Billing
Metered billing is a concept where customers need to pay based on product or service consumption. Some companies charge on the same principle instead of charging a fixed amount. This kind of billing can be prepaid (where customers need to pay earlier before availing of the service) or postpaid (where customers need to pay after consuming the service).
Installment Payment
Have you heard of or seen ‘Buy Now Pay Later’ somewhere? Some companies are open to receiving installments for their payment for selling services and products. In this case, companies recognize their revenue before the entire cash collection. Some e-commerce businesses offering installment payments recognize their revenue once the shipping is done.
GAAP Revenue Recognition Principles
Revenue recognition is always as per the principle of revenue recognition. Also, the recognition of revenue is always done according to an income statement. It takes place at the time of realization and earning and not at the time of receiving cash.
The key principles of GAAP revenue recognition are listed.
Delivery Occurrence or Rendered Service: Revenues are recognized generally when the business owner provides a service or product to the customer.
Persuasive Evidence of an Arrangement: Revenue must always be recognized when persuasive evidence of an arrangement between seller and buyer takes place. Purchase orders, contracts, or any other agreement are some form of evidence.
Collectibility is Reasonably Assured: When the collectibility of the amount owed is reasonably assured, revenue should be recognized at that time.
Consistency and Comparability: There should be consistent revenue recognition from period to period in the same company. It warrants that financial statements always reflect the company’s financial stage accurately.
The Five Steps of Revenue Recognition
According to ASC 606, the revenue recognition process involves the following five steps:
1. Contract identification with a particular customer
Initially, there is contract identification with particular customers. Two parties agree to sign an agreement for an enforceable obligation. Several criteria must be met for an agreement to be legally binding.
Details like payment terms, pricing, and key performance indicators may also be mentioned in the contract. The same applies to SaaS and B2B entities.
2. Tracking contractual performance obligations
Performance obligations are the goods and services that a company gives to the customer, and in return it takes charges.
Companies must consider the types of goods and services exchanged for payment when making performance obligations under the contract.
3. Identify the transaction price
In transaction price identification, that amount is considered that the seller directly gets for the given product or service. Additionally, it can also cover potential discounts, return policies, and additional fees. In many cases, transaction price tracking is simple. The translation price includes an amount that can be variable, fixed, or contingent upon certain conditions.
4. Transaction price allotment across performance obligations
After transaction price determination, it is important to allocate it to each performance obligation in the contract. Establish the standalone selling prices for each performance obligation and allocate them accordingly. This is the first and the most important step.
However, uniform allocation of transaction prices is not possible across each performance obligation.
5. Revenue recognition when the contracting entity fulfills the performance obligation
Once the performance obligation is fulfilled, the company should recognize revenue.
It is not mandatory for a company to receive payment before revenue recognition. Instead, customers must receive the promised product or service in exchange for their payment.
Benefits of Revenue Recognition Automation
After knowing what revenue recognition is, you must know the merits of automation in revenue recognition. There are multiple merits to revenue recognition automation.
- Faster processes: Companies enjoy fast speed processing of their revenue recognition due to automation. This makes it easy to identify revenue correctly and on time.
- Improved accuracy: Revenue recognition automation prevents human errors. It does not include miscalculations and manual data entry.
- Increased visibility: Revenue recognition software provides valuable insights and visibility into the entire revenue recognition process. It offers companies real-time insight into the actual proportions they should recognize.
- Good investor relations: Companies are assured to report their financials correctly through transparent accounting.
- Lower cost to comply: Companies can save time and money by reducing manual data entry and calculation.
What Are Types of Revenue Recognition Software?
There are multiple revenue recognition software solutions. You can find software for big enterprises to small businesses including full-featured cloud-based solutions.
Accounting software: Companies can use accounting software to manage their financial activities including recognizing revenue. It also automates the revenue recognition operation.
CPQ software: Companies can get help from configure, price, and quote (CPQ) software to accurately determine the translation price. It also ensures that across customers, revenue is acceptable in a consistent manner.
ERP: Enterprise Resource Planning offers companies the tools. It streamlines and automates various financial processes like revenue recognition once performance obligations are fulfilled.
CRM software: Many Customer Relationship Management systems include a feature, useful for companies with revenue recognition.
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Conclusion
So here we end up with what revenue recognition is all about. Revenue recognition methods are crucial, and every business must understand them well. It is more about following the rules for accurate financial reporting rather than counting cash. Businesses can present their company’s financial status to investors. Moreover, it is also helpful in making an informed decision about a company’s future goals and long-term vision.
FAQs
Jayanti Katariya is the founder & CEO of Moon Invoice, with over a decade of experience in developing SaaS products and the fintech industry. He holds a degree in engineering. Since 2011, Jayanti's expertise has helped thousands of businesses, from small startups to large enterprises, streamline invoicing, estimation, and accounting operations. His vision is to deliver top-tier financial solutions globally, ensuring efficient financial management for all business owners.
