Let’s start with the basics – what exactly is revenue recognition? Revenue recognition determines the specific conditions and when revenue can be realized. Simply put, revenues can only be recognized when realized and earned – not necessarily when services are rendered or payment is received. On the surface, it sounds easy enough. However, there are a number of revenue recognition methods and it’s critical that your revenue is accurately measured and recognized.
To take some of the guesswork out of the revenue recognition equation and to ensure consistent revenue recognition practices, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board jointly issued a set of requirements that companies must satisfy before they can recognize revenue. Designed to govern revenue reporting and simplify compliance, ASC 606 and IFRS 15 are revenue recognition standards that consist of 5 steps.
Determining The Right Revenue Recognition Methods
Gone are the days of simplistic business models made of a one-time sale, of a single product, at a predetermined price. Today’s increasingly complex software as a service (SaaS) business models offer a variety of pricing models, packages and bundles, as well as payment terms and payment options. If you run a SaaS business, you probably know too well the added complexities of revenue recognition. As a quick reminder of how to overcome these inherent intricacies, take a look at our recent blog that was created to put you on the path to simplifying your SaaS revenue recognition processes.
When it comes to recognizing revenue, there are five primary methods that you can use – depending on your business model.
1) Sales Basis Method
Revenue is recognized at transaction completion, like when the product is delivered to the customer or services are rendered. This occurs even if cash was received prior to contractual fulfillment. For example, if a customer purchases an annual software subscription for $1200, you can only recognize $100 of revenue every month.
2) Percentage of Completion Method
This is typically used by companies engaged in long-term projects, like construction companies. A percentage of revenue can be recognized if there is a long-term contract in place and the project is defined in a way that allows for the percentage of completion to be estimated. Imagine you own a construction company that contracts to build 3 resorts for a total of $3 million ($1 million/resort). Using the percentage of completion method, revenue recognition can be computed using one of two methods:
- Milestone: For every resort completed, you can recognize $1 million. Note: Completion can be defined further to detail the percentage of completion at each of the resorts. For example, the contract can be written so that you can recognize $250,000 for every 25% of resort completion.
- Cost-based: A bit more complicated, this method requires you to compare cost incurred to date with the estimated total cost. Using the resort construction example, say your expected costs for the three resorts total $1.5 million and that you have incurred $150,000 in costs at the end of the first quarter. At this point you’d be able to recognize the project as 10% complete ($1.5 million / $150,000 = 10 percent).
3) Installment Method
If a company is concerned with a customer’s ability to pay, the Installation Method comes into play. This revenue recognition method is most commonly used for high-value purchases such as vehicles and real estate. As an example, let’s use the purchase of a new vehicle at a total cost of $25,000. We’ll assume the customer puts $1,000 down and the monthly installments equal $375.00. At the time of the sale, you’ll be able to recognize the $1,000 once the vehicle transfers to the customer. Then each month upon receiving the payment, you will recognize $375.00.
4) Completed Contract Method
This revenue recognition method is only used when the requirements of completion percentage can’t be estimated or the contract isn’t enforceable. Let’s assume your company produces and sells laptops and a client places an order for 900 laptops. The arrangement is for 3 shipments of 300 laptops each in 3 consecutive quarters. The terms of the contract won’t be met until the third and final shipment of 300 laptops, so revenue can’t be recognized until that time.
5) Cost Recoverability Method
One of the most conservative revenue recognition methods is the Cost Recoverability Method. This is typically used when the company can’t reasonably estimate the total expense required to complete a project. Using this method, revenue can only be recognized once all expenses are incurred and accounted for. For example, say your company created it’s own customer relationship management (CRM) software at a total cost of $1 million. A few years later, you make the software license available to other companies. This results in total sales of $300,000 the first quarter. At this point in time, the $300,000 would serve as an offset to the $1 million cost. It is only after you’ve sold $1 million in software licenses (offsetting the original balance) that revenue from sales are recognized.
Take the Guesswork out of Revenue Recognition
Regardless of your business model, correctly recognizing revenue is one of the most critical tasks your financial team undertakes. From product inception through revenue recognition, you need a system that empowers you to monetize any revenue opportunity, while adhering to ASC 606 and IFRS 15. Unlike other cloud and legacy billing solutions, BillingPlatform enables you to remove the complexities of revenue recognition. Even for the most complex business models and billing scenarios!
With a rules-based revenue recognition engine, we’ve helped companies around the world define company-specific rules and make assignments in real-time. All while giving them the agility to speed financial closing processes. With real-time sub-ledger transactions, our cloud-based billing system seamlessly integrates with downstream enterprise resource planning (ERP) and accounting systems, providing everything you need for complete financial control. Does that sound like something your company could benefit from? If so, our team is ready to help.