Let’s start with the basics – what is revenue recognition? Revenue recognition is an accounting principle that outlines when and how businesses record revenue. It focuses on when revenue is earned and realizable, rather than when payment is made to ensure accurate financial reporting. Additionally, it determines the specific conditions of when revenue can be realized.
Simply put, revenue can only be recognized when earned and realized – not necessarily when services are rendered or payment is received. On the surface, it appears easy enough. However, there are numerous revenue recognition methods and it’s critical that your revenue is accurately measured and recognized.
In this blog we’ll dive into the various revenue recognition methods, cover why some revenue recognition methods are better for certain industries than others, and discuss how different revenue recognition methods affect financial statements.
Revenue Recognition Methods
Since businesses operate in vastly different industries, sell different types of goods and services, and structure contracts in diverse ways, a single revenue recognition method would not accurately reflect the economic reality of the majority of transactions. To counter this problem, there’s a cornucopia of revenue recognition methods, each designed for specific reasons. Here’s some key reasons as to why multiple revenue recognition models exist.
Different business models and transactions: For example, a software company can’t use the same revenue recognition method as a manufacturer selling machinery. Similarly, a retail store selling physical goods needs a different revenue recognition method than a construction company working on long-term projects.
Matching revenue with performance: Revenue should be recognized when a company satisfies its performance obligations, not necessarily when cash is received.
Compliance with accounting standards: Under GAAP and IFRS, revenue recognition must reflect the transfer of control of goods or services. These standards offer principles and guidance that result in different revenue recognition methods.
Financial reporting accuracy: Companies choose revenue recognition methods that best reflect how they earn revenue in order to provide accurate and meaningful information to stakeholders. Additionally, the method used impacts reported earnings, tax liabilities, and performance evaluation.
Industry-Specific Revenue Recognition Methods
While there are many revenue recognition methods available, the ‘right’ one depends on the nature of the business and the company’s contract structure. While revenue recognition methods can be industry specific, ASC 606 and IFRS 15 provides a general five-step model for revenue recognition.
Let’s look at a few key industries that have specific revenue recognition practices.
Software as a Service (SaaS) and Subscription: The most common method is straight-line over the subscription period since services are delivered over time.
Software and Technology: Typically use the percentage of completion revenue recognition method since revenue may be split across licenses, support, and updates.
Telecommunications: The bundled contracts typical of this industry requires revenue splitting, making allocation across service and equipment the method of choice.
Retail and Consumer Goods: Sales are typically immediate and straightforward, so the point-in-time revenue recognition method is most commonly used.
Construction and Engineering: The percentage of completion revenue recognition method is typically used as projects often span several years and involve progress billing.
Real Estate: The method of revenue recognition is dependent on when the buyer takes control of the asset, however the most commonly used methods are point-in-time or over time.
While most companies follow similar principles for revenue recognition, they may apply them differently depending on industry practices, contract terms, regulatory environment and company-specific policies.
Although above we combined SaaS and subscription, let’s compare the similarities and differences in how a SaaS company vs a subscription company recognizes revenue.
Similarities in Revenue Recognition
- Recurring Model: Both generate recurring revenue – monthly, quarterly, annually.
- Over-Time Recognition: Both recognize revenue over time and not up front.
- Use of ASC 606 / IFRS 15: Both follow the 5-step revenue recognition model under accounting standards.
- Performance Obligations: The obligation is to provide access to software/goods over a period of time.
- Deferred Revenue: Cash received in advance is recorded as a liability, until the software/services are delivered.
Differences in Revenue Recognition
Feature | SaaS Company | Subscription Company |
Nature of Product | Cloud-based software access | Physical goods or content services |
Delivery | Usually digital and continuous access | Can be digital (streaming) or physical (monthly boxes) |
Performance Obligations | Most often a single obligation, as in providing continuous access to software | May have multiple obligations such as goods, bonus items, and services |
Revenue Timing | Straight-line over the contract period | Recognized when each item is delivered |
Upgrades/ Features | May have tiered pricing or usage-based components | May have tiered pricing or usage-based components Usually fixed price, although some add-ons may be separate |
Implementation Fees | Often included or separately recognized over the contract term | Rare, with some exceptions |
Let’s put the above in action.
Imagine a SaaS company has a customer that pays $12,000 for a 12-month software license. Revenue is recognized as $1,000 per month for 12 months.
Now imagine, a subscription box company customer pays $120 for a 6-month subscription to dog treats and toys. Revenue is recognized as $20 each month, when the box is shipped.
Types of Revenue Recognition Methods
While there’s no shortage of revenue recognition methods, we’re going to cover the top 9 methods.
- Point of Sale Method: Revenue is recognized only when a sale transaction occurs. This means that the goods or services have been delivered to the customer and the invoice is issued or payment is received.
- Completed Contract Method: Used primarily for long-term contracts where revenue and expenses are recognized only when the contract is completely fulfilled.
- Input Method (Cost-to-Cost Method): Revenue is recognized based on the proportion of costs incurred to date, relative to the total estimated cost of the project.
- Output Method: Revenue is recognized based on the value of the goods or services delivered, milestones achieved, or units completed.
- Percentage-of-Completion Method: Used primarily in long-term projects, such as construction or engineering to recognize revenue as work is performed.
- Sell-Through Method: Typically used by manufacturers or suppliers who sell their products through distributors or retailers. Under this method, revenue is not recognized at the point of sale to the distributor, but when the product/service is sold by the distributor to the end customer.
- Accrual Method: This key principle of accrual accounting refers to recognizing revenue when it is earned, regardless of when cash is received.
- Cost-to-Cost Method: This method recognizes revenue over time under the percentage-of-completion method and is most commonly used in long-term contracts.
- Proportional Performance Method: Based on the extent of work completed, it is typically used to recognize revenue over time.
The Impact of Revenue Recognition Methods on Financial Statements
Different revenue recognition methods can significantly impact a company’s financial statements, especially the income statement and balance sheet. Here’s a breakdown of how / why this happens.
Method | When Revenue is Recognized | Impact on Income Statement | Impact on Balance Sheet |
Point of Sale | At delivery or sale | Revenue and profit are recognized immediately | Receivables increase until collected |
Percentage of Completion | Based on progress toward completing a project | Revenue and profit are gradually recognized over time | Assets and liabilities reflect ongoing costs and billing |
Completed Contract | Only when the project is complete | Neither revenue nor profit is recognized until completion | Work-in-progress costs shown as an asset until completion |
Installment Method | When cash is received | Revenue is recognized over time –as cash is collected | Receivables and deferred revenue balances until cash is received |
Cost Recovery Method | Revenue is recognized only after costs are recovered | Profit is recognized very conservatively, after recovering costs | Costs shown as assets until recovered |
Installment Recovery Method | When cash is collected, typically used when collectability is uncertain | Revenue and gross profit are recognized proportionally as cash is collected | Accounts receivable is recorded as usual; however a portion of the gross profit is deferred |
Take the Guesswork out of Revenue Recognition
BillingPlatform delivers intelligent revenue recognition software that simplifies the allocation, reconciliation, monitoring and recognition of revenue across your various pricing models, billing methods, and promotional offers – all while ensuring compliance with ASC 606 and IFRS 15 standards.
Our solution integrates real-time revenue recognition with comprehensive automation for streamlined financial processes. Are you ready to take the guesswork out of revenue recognition? If so, our team is ready to help!
