A generally accepted accounting principle (GAAP), revenue recognition identifies the specific conditions in which revenue is recognized and how a company should account for it. While on the surface it sounds easy enough, there are complexities that arise when recognizing revenue. At the core of revenue recognition is knowing exactly when revenue received can be considered earned. This is where the revenue recognition principle comes into play.
Adding to the inherent complexities of revenue recognition are the varying ways that revenue is recognized. There are two primary accounting methods – cash basis and accrual basis. Each contains pros and cons and therefore are better situated for some industries than others. Before jumping in you may want to get a better idea of which accounting method your business is best suited for.
The Revenue Recognition Principle: What is it?
As previously mentioned, the revenue recognition principle determines when revenue can be recognized. In its most simplistic scenario, recognizing revenue takes place when the goods have been transferred or when services have been performed. However, it gets more complicated depending on your business model. To accurately and consistently recognize revenue there are five primary methods that can be used.
- Sales Basis Method: Revenue is recognized at the completion of a transaction.
- Percentage of Completion Method: This involves computing the amount of revenue that can be recognized with one of two methods – milestone or cost-based.
- Installment Method: Primarily used for high-value purchases or when a business is concerned with the customer’s ability to pay.
- Completed Contract Method: This method is used when the requirements of the transaction completion percentage can’t be estimated, or the contract isn’t enforceable.
- Cost Recovery Method: This is the most conservative revenue recognition method. It’s typically used when the business can’t reasonably estimate the total expenses they will incur to complete the project.
Regardless of your industry or business model, recognizing revenue is one of the most important tasks your financial team handles. So it’s important to determine the right revenue recognition model – one that will enable you to recognize revenue as soon as possible, while still adhering to financial regulations.
Financial Regulations Add Complexity
Collecting revenue is not only exciting but a mainstay that ensures the longevity of your company. In light of Accounting Standards Codification (ASC) 606, this topic has become extremely important in recent years. ASC 606 revenue recognition standardizes how companies should recognize revenue. To help organizations adhere to the ASC 606 standard, there’s a five-step process consisting of:
- Identifying the contract(s) with a customer
- Identifying the performance obligations in the contract(s)
- Determining the transaction price
- Allocating the transaction price for the performance obligations in the contract(s), and
- Recognizing revenue when, or as, the entity satisfies a performance obligation was defined
If you need to dig deeper into ASC 606, we’ve compiled The Four W’s of ASC 606 Revenue Recognition to help. Because as you can see, staying within the ASC 606 or IFS 15 guidelines while recognizing revenue ASAP isn’t an easy task. This is why so many companies develop and adhere to a revenue recognition policy.
Why You Need a Revenue Recognition Policy
A revenue recognition policy is a document that recaps your revenue recognition principle processes and methodologies. While not all companies take the time to create one, it’s in their best interest to do so. Why? To start, the most common type of fraud is improper revenue recognition. Second, a well-designed revenue recognition policy helps your financial team prepare financial statement disclosures.
While not easy to create, there are eight key performance obligation considerations that a revenue recognition policy needs to take into consideration.
- Description of the performance obligation
- Contract arrangement for the performance obligation
- Timing of the transfer of the performance obligation to the customer
- Information about the economic factors that may affect a performance obligation
- Payment terms for performance obligation
- How the performance obligation of the satisfaction timing relates to the typical payment timing
- Obligations for returns, refunds, or types of warranties
- Determination of whether the company is a principal or agent for the performance obligation
As you can see, creating this type of document takes thought and time. So we uncovered what every revenue recognition policy should include and shared an example of one created by Harvard University. The policy is complex and time-consuming, indeed. And if you own a software as a service (SaaS) business, there are some inherent nuances in the revenue recognition principle.
SaaS and Revenue Recognition
SaaS businesses are typically paid in advance by the customer, either on a monthly, quarterly, semi-annually, or annual basis. However, the revenue received upfront is realized throughout the contract period. Say a customer paid $12,000 for access to your software for twelve months. Once you have cash in hand, can you recognize the entire $12,000? The answer is no. Each month you’re able to recognize $1,000 until the conclusion of the 12-month contract.
However, further complexities in recognizing revenue can arise for SaaS businesses when one or more of the following occur:
- Subscription cancellations prior to the contract end date
- Upgrades from basic plans to top-tier plans
- Downgrades from top-tier plans to basic plans
- Changes to services provided
- Inability to collect money owed
In addition, most SaaS businesses offer a variety of subscription plans and pricing models such as usage-based, hybrid billing, dynamic billing, etc., along with a nearly infinite number of combinations.
Remember that the revenue recognition principle determines when you can recognize revenue, and the goal for every business is recognizing revenue as soon as possible. All while staying within the guidelines of ASC 606 or IFRS 15. Recognize revenue too early and you’re at risk of a GAAP violation, but delay revenue recognition and you may lose finance credibility.
Revenue Recognition: Simplified
Regardless of your business model, the revenue recognition principle is a complex process, but it doesn’t need to be. There are numerous ways to alleviate some of the inherent complexities and simplify revenue recognition.
With BillingPlatform as your revenue recognition partner, you’re able to follow the revenue recognition principle, while adhering to ASC 606 or IFRS 15 standards. With us, you get all the tools you need such as the ability to automatically assign financial transactions and execute revenue recognition as events take place. Plus our cloud-based revenue recognition solution supports the entire quote-to-cash process and enables you to configure every aspect of revenue recognition – without IT assistance or custom coding. Learn more and request a 14-day trial today.
