What is revenue recognition?
Revenue recognition is an accounting method for recording income at the time the business earns it instead of when it receives the payment. Revenue recognition applies to companies using accrual-basis accounting.
Companies often receive money upfront before they complete a job or provide a product. For example, a software-as-a-service (SaaS) company might collect payment for an entire year upfront instead of monthly. If the company uses accrual-basis accounting, it doesn’t report that payment until it has rendered services.
Revenue management software allows organizations to record cash inflow, analyze performance trends, and monitor financial health. The software typically integrates with an organization’s existing tech stack, including client relationship management (CRM) software, to streamline accounting processes.
Basic elements of revenue recognition
The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) created an Accounting Standards Codification known as ASC 606 to govern revenue recognition. ASC 606 lists five steps accountants must follow to stay consistent and compliant.
- Identify the contract. Companies may enter into agreements that are oral or written. The contract clarifies payment terms in exchange for goods or services.
- Locate the performance obligations. The contract lists the company’s performance obligations, the goods or services they promise to fulfill for the customer, and the timeline for performing those duties.
- Discover the transaction price. The customer promises to pay an amount for the goods or services within the contract. They may agree to fixed consideration, such as paying $8,000 for a used vehicle, or to variable consideration, including rebates, refunds, or penalties. If variable consideration is involved, the accountant determines a transaction price, which may differ from the amount listed in the contract.
- Assign the transaction price. At this stage, a company must correlate each transaction price with the performance obligation it matches.
- Recognize revenue. The company can recognize revenue as they fulfill the goods or services listed in the contract or once they have met all of its obligations.
Revenue recognition methods
Businesses using accrual-basis accounting rely on the revenue recognition principle to ensure they properly account for all earnings. Choosing a suitable method for accounting for these earnings is often complex. Depending on their business model and performance obligations, companies can choose from these five methods.
- Sales-basis method: A business recognizes revenue at the time of sale. This method is standard for retailers since the customer typically pays when the company gives them the product. It becomes more complex when the customer pays upfront for services distributed over time. In this case, the time of sale is when the customer receives the goods or services. In other words, even if a customer has paid for an annual subscription, the company doesn’t recognize the revenue earned until the end of each month of providing services.
- Percentage of completion method: A business records revenue when they complete a percentage of a project or hit specified milestones. This method is ideal for companies that work on projects that take months or years to complete. For example, a construction company building an outlet mall can record revenue earned when they finish building the first 25% of the project.
- Installment method: A business recognizes revenue in increments as the customer makes payments. A company may choose this method for big-ticket items, such as vehicles or real estate, where customers might default on payments. The company records each monthly payment as revenue when the customer pays.
- Completed contract method: A business records revenue when they have delivered all goods or services to a customer. This method works well for shorter contract terms or delivery periods. If a restaurant orders 100 chairs from a supplier, who ships them in sets of 25 over eight weeks, the supplier doesn’t record the revenue earned at the beginning or when they shipped each group of 25. Instead, they would record the money earned when they fulfilled the terms of the contract.
- Cost-recoverability method: A business recognizes revenue when it has earned back the expenses it invested in the product or service. For example, a business spends $10,000 creating a gaming application. Downloading the app costs $4, and 750 customers buy it the first month. The $3,000 earned that month isn’t recorded as income; instead, it offsets the costs. Once the company offsets $10,000, it starts recognizing revenue earned.
Importance of revenue recognition
Small companies and large enterprises alike need to keep accurate financial records for reporting and compliance purposes. Some specific advantages to following the revenue recognition principle include:
- Maintaining compliance. Following the five-step revenue recognition method assures that a company will maintain compliance with Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS).
- Conveying profit and loss. A consistent method for reporting revenue is vital because investors want to keep accurate tabs on a publicly held company’s performance. It’s just as important that the company’s owners and leaders monitor their revenue to make smart decisions about hiring or scaling.
- Avoiding fraud and manipulation. Revenue is one of the main indicators of a company’s financial health, so companies may face the temptation to misrepresent or inflate this metric. For example, a furniture company might offer 0% financing on big-ticket items and sell hundreds of items, but several customers never pay. If the company had recorded the revenue upfront, it has misrepresented its earnings. By following the standards set out by governing bodies, the company avoids any confusion and keeps its bookkeeping above board.
Take your learnings one step further by discovering how revenue sharing works and why it's important.
Kelly Fiorini
Kelly Fiorini is a freelance writer for G2. After ten years as a teacher, Kelly now creates content for mostly B2B SaaS clients. In her free time, she’s usually reading, spilling coffee, walking her dogs, and trying to keep her plants alive. Kelly received her Bachelor of Arts in English from the University of Notre Dame and her Master of Arts in Teaching from the University of Louisville.
