What is Revenue Recognition: A Beginner’s Guide
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Correctly recognizing business revenue is a big deal. It can make or break your ability to attract investors or secure a loan, and influence your business’s valuation in a funding round, acquisition, or IPO.
In this guide, we’ll explain why revenue recognition matters and outline the steps you should take to make sure your business’s accounting bases are fully covered.
What is Revenue Recognition?
Revenue recognition refers to the way a business recognizes and accounts for its revenue, and is an important part of compliance with generally accepted accounting principles (GAAP). Using the accrual method, revenue is typically recognized on the income statement in the period when it’s “realized and earned” (e.g. when goods are sold, or a service is provided)—which might not be the same time that cash is received.
For businesses that collect cash when the transaction occurs – for example, a retail store – recognizing revenue is simple: their revenue is “realized and earned” when cash is deposited into a cash register or bank account.
For companies that provide goods or services over a period of time, however, or for businesses that take money from customers before goods/services are provided, knowing when to recognize and account for revenue can be tricky. In this blog, we’ll focus on what those businesses need to know to correctly recognize their revenue.
Which Businesses Need to Worry About Revenue Recognition?
While revenue recognition is important for all businesses, certain types of businesses are more affected by accrual revenue recognition principles, including:
- Subscription-based businesses (SaaS companies, publishers, membership sites)
- Businesses who receive upfront payment for projects that extend over a period of time (contractors, consultants, construction companies), with specific deliverables or milestones
- Professionals who collect a retainer from clients
In other words, if your company provides longer-term engagements but is paid upfront or at the end, there’s a good chance you may need to ensure you’re correctly recognizing revenue. If you’re not sure if revenue recognition is a concern for your business, it’s a good idea to consult with your finance professional.
Revenue Recognition: Key Terms
Familiarize yourself with these key terms. They’ll come in handy as we dive deeper into the process of recognizing revenue below.
Recognized or Earned Revenue
Recognized revenue, more often called “earned revenue,” is when a product or service is provided and cash has been received. Recognized revenue is revenue entered into the books as income.
The simplest example of earned revenue is when a customer pays for a product in-store, and cash is received and accounted for.
Accrued revenue is revenue that has been earned by providing a good or service, but for which no cash has been received. Accrued revenue is recorded as a receivable on the balance sheet to reflect the money that customers owe the business for the goods or services they purchased.
Businesses that engage in long-term projects where full payment is received on project completion typically need to include accrued revenue in the books. When services or products are provided over the course of many months, accrued revenue is recorded periodically during the project even though any cash is yet to be received.
Deferred revenue is recorded when a business collects cash from customers, but has not yet provided a good or service. This money is classified as a liability for the business because until it is recognized as revenue, the business technically owes this money to its customers.
An example of deferred revenue would be a company that collects annual prepayment for a year’s subscription. Even though they have the full year’s cash, the revenue isn’t recognized all in one go because the company hasn’t provided a full year’s service.
Revenue Recognition Examples
Here are a couple of simple examples that demonstrate when a business might recognize its revenue.
For a Business that Sells Physical Goods
Imagine that your business makes furniture and sells it to a variety of customers.
One of your customers visits your store, chooses a desk, and buys it for $400.
That’s earned revenue: your business delivers a product, your customer pays cash for it on the spot, and the $400 payment is recorded as income in your books.
But your other customer is a large company, which only pays for contracts on project completion. They ask you to make 12 specialized custom desks worth $1,000 each. So they sign a contract for $12,000, which they agree to pay in full once all of the desks have been delivered.
If your business simply recorded that $12,000 payment in the books as one lump sum payment, your monthly revenue totals would be skewed—they wouldn’t reflect the revenue your business was generating each time it delivered a desk. It would only reflect revenue after a year’s worth of work, once all the desks have been completed.
Instead, that $12,000 would be recorded as accrued revenue. Each time you delivered a desk, you would move another $1,000 to earned revenue. When all desks are delivered and your client pays in full, all $12,000 will be recognized as earned revenue, and your accounts receivable balance will be reduced accordingly.
For a Subscription-Based SaaS Company
Let’s say your SaaS company sells annual subscriptions to users for $100/month. Customers pay $1200 upfront for 12 months of access to your online software.
Instead of recognizing the full payment of $1200 as revenue in the month that a customer signs up, you would likely only recognize $100 of that revenue each month over the course of that customer’s 12-month subscription.
In the first month of that customer’s subscription, you would account for the following:
- $100 — Earned Revenue
- $1100 — Deferred Revenue
Each month the amount of deferred revenue would decrease, as you recognized it by delivering the service.
Why Revenue Recognition Matters
Here’s why revenue recognition matters, and why you need to ensure that your business is getting it right.
It Accurately Reflects the Financial Health of a Company
Revenue recognition ensures that a company’s financial performance is accurately reflected in each reporting period.
To understand how this works, let’s revisit our previous example.
If your SaaS company recorded a customer’s annual subscription payment ($1200) in a single month, the company’s revenue would be skewed, looking something like this:
- January: $1200
- February: $0
- March: $0
- April: $0
…and so on.
Instead, thanks to the rules of revenue recognition, $100 would be “realized and earned” every month over the 12-month period, reflecting a more accurate picture of your company’s financial health on its financial statements.
Investors and Creditors Expect It
Revenue is an important metric for investors and creditors. And it’s a big red flag when a company is being creative with the way it recognizes revenue.
Your investors will want to see that you’re following standards and best practices when you report revenue. Not only does this give a good impression for your business’s maturity, it also makes it easier for investors and creditors to review your company’s financial statements and see how things are performing.
How to Correctly Recognize Revenue
Here is the standard five-step process to correctly recognize revenue:
1. Identify Your Contractual Obligations with the Customer
Ensure that every agreement you sign with a customer clearly indicates which goods or services you’re delivering, and the payment terms for those goods or services.
2. Identify the Performance Obligations in the Contract
Does your business’s contract contain more than one good or service? If so, make sure they’re identified and separated out.
3. Determine the Total Transaction Price
Clearly indicate how much you’re charging for all of the goods and services to be delivered.
4. Determine a Price for Each of the Obligations on the Contract
If your contract contains more than one good or service, include an itemized breakdown of the prices for each individual good or service your business will deliver.
5. Recognize Revenue as You Deliver Each Separate Good or Service
Once you’ve made it through steps 1-4, you can recognize revenue for each of the goods or services you separated and priced out.
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