Why is revenue recognition one of the most difficult tasks your organization handles? The short answer is that by its very nature, revenue recognition is complicated. However, standards have and continue to be put in place to streamline this often problematic process. This blog provides revenue recognition examples and shows what you can do to alleviate the complexities of revenue recognition.
Designed to improve the clarity, consistency, and comparability when communicating financial information, generally accepted accounting principles (GAAP) is a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB) that public companies in the US must follow. If you do business internationally, there are other accounting principles that you must adhere to such as the International Financial Reporting Standards (IFRS).
5 Steps of Revenue Recognition
Established by both the FASB and International Accounting Standards Board (IASB), ASC 606 and IFRS 15 are recent revenue recognition standard that affects all businesses (public, private, and non-profit) that enter into contracts for the transfer of goods or services. According to ASC 606 / IFRS15 principles, there are five steps that companies must adhere to in order to recognize revenue.
- Identify the contract with a customer: Whether written, oral, or implied, the contract is a legally binding document that defines the rights and obligations of both parties.
- Identify the performance obligations in the contract: Describes the products and/or services promised to the customer (i.e. performance obligations). If the products or services are distinct, they are accounted for separately within the contract.
- Determine the transaction price: Establishes the amount the customer is expected to pay in exchange for the products or services.
- Allocate the transaction price to the performance obligations in the contract: Explains how the transaction price is to be allocated across performance obligations (i.e. products or services).
- Recognize revenue when (or as) performance obligations are satisfied: Revenue is recognized when performance obligations are satisfied by transferring the products or services from the seller to the buyer.
On the surface these steps look simple enough, however, revenue recognition is anything but easy. For starters, to ensure adherence with GAAP and other regulatory requirements, promote consistency, and ensure revenue is not misstated, a revenue recognition policy should be created and closely followed. This blog digs a bit deeper into creating a revenue recognition policy.
Although there are two main accounting methods – cash basis and accrual basis – there are a number of ways revenue can be recognized, adding to the complexity.
What’s the Best Revenue Recognition Method for Your Business?
Before diving into the various ways revenue can be recognized, let’s take a look at pros and cons of both accounting methods.
As defined by Investopedia, cash basis refers to a major accounting method that recognizes revenues and expenses at the time cash is received or paid out.
Easy to understand
Provides a limited view of income and expenses
Provides an accurate representation of how much cash the business has at any point in time
Business liabilities aren’t easily exposed
Is a single-entry system, reducing the need to implement an accounting program
Customer liabilities aren’t easily exposed
Often used by start-up companies or small businesses, cash-basis accounting contains some restrictions that will prevent usage if you:
- Sell products or services on credit
- Require inventory to account for income
- Offer credit to customers
- Have annual gross receipts of more than $25 million for three preceding tax years, except if you’re a small business that doesn’t keep inventory
Defined by Investopedia, accrual accounting measures a company’s performance and position by recognizing economic events regardless of when cash transactions occur.
Provides a more accurate representation of cash flow and profitability
Requires at least monthly reporting
Enables easier forecasting of future revenues and expenses
Taxes are paid on revenue not yet received
Is the preference of investors and the GAAP
Smaller companies may lack resource expertise
Now that we’ve covered the two primary accounting methods, let’s discuss the five main ways revenue can be recognized.
- Completed contract method: Allows you to recognize revenue when the entire contract is fulfilled and when all performance obligations have been met.
- Cost recovery method: Prohibits companies from recognizing revenue related to a sale until costs associated with the sale have been paid by the buyer. In other words, you can only recognize revenue after recouping the costs associated with the performance obligations.
- Installment method: Typically used for large dollar purchases, it enables the company to recognize a percentage of the total revenue as payments are received.
- Percentage of completion method: Enables companies to recognize a percentage of the revenue as contractual milestones, deliverables, or other indicators are reached.
- Sales-based method: Regardless of whether the customer pays with cash or credit, you can recognize revenue at the time of sale.
What’s the best revenue recognition method for your business? Essentially, it depends on your industry. For example, if you’re in retail sales the most logical choice would be the sales-based method. If you own a car dealership you may opt for the installment method.
Revenue Recognition for SaaS Companies
Unlike virtually any other business model, software as a service (SaaS) revenue tracking is notably more complex because of the unique characteristics of its revenue recognition. Focused on monthly recurring revenue (MRR), SaaS companies live by MRR figures to gain a better understanding of comparable business trends and to ensure financial growth. And, what do you think is at the center of MRR… revenue recognition!
Although the SaaS business model provides predictable and repeatable revenue streams, it’s not always easy to know when revenue and expenses should be recognized. While this business model boasts recurring revenue, accounting complications arise from upgrades and downgrades, packages, bundles, discounts, and promotions, lost revenue due to dunning, customer churn, credits or refunds, etc.
For these reasons, the accrual-basis accounting method is preferred by the majority of SaaS companies. Let’s use an example to explain why. We’ll assume that the ABC SaaS Company is operating as a subscription-based business and customers have their choice of being billed monthly, quarterly, or annually. Accrual-basis accounting enables SaaS businesses to recognize revenue when it’s earned. If a customer pays an annual subscription fee of $12,000 in advance, the ABC SaaS Company is able to recognize $1,000 in revenue for each month of the subscription. What happens to the revenue that was collected but can’t yet be recognized? Referred to as deferred revenue, it is placed in a liability account until the service has been provided.
Whether you’re just starting your SaaS business or are on track for substantial growth, one thing is certain – manually handling SaaS accounting functions is not only tedious and time-consuming but error-prone.
Simplify Revenue Recognition
Because of the complexity and uniqueness, SaaS companies need systems that are built for their pricing models, can automate repetitive financial tasks, and ensure ASC 606 and IFRS 15 compliance. BillingPlatform provides native cloud-based solutions that deliver this and much more. Our industry-leading BillingCloud solution gives you the freedom to easily transition from simple one-time subscription-based pricing models to creative metered and usage-based plans.
By simplifying revenue management with a rules-based revenue recognition engine, you’re able to define rules specific to your company and make assignments in real time, as billing, payments, and credit events take place. And that’s not all! To speed financial closure processes, BillingPlatform provides real-time subledger transactions that integrate into downstream enterprise resource planning (ERP) and accounting systems. With BillingPlatform, you get everything you need in a single cloud-based platform to run your business with greater efficiency, accuracy, and control. Does that sound like something your company could benefit from? If so, our team is ready to help.