How Does Revenue Recognition Work?
Here’s a simple question: Is it always easy to track the revenue your company generates month-to-month? Retail business owners will probably be the quickest to answer in the affirmative. If you’re an entrepreneur, a freelance business owner, or a contractor, then the question may have thrown you off a bit.
With some projects getting paid upfront and others meeting unforeseen delays, the financial ground of an entrepreneur is always somewhat shaky. Keeping track of your earnings on a month-by-month basis is what we call revenue recognition and it can be a tad bit trickier than you’d think.
What Is Revenue Recognition?
In simplest terms, revenue recognition refers to identifying when your business makes a revenue. In cash-based accounting, figuring this out is a lot easier. As soon as the cash hits your register, that’s when you know the revenue has been made.
Accrual-based accounting is where things get trickier. This system of accounting recognizes the income only at the time when it’s earned.
The generally accepted accounting principles (GAAP) have been designed for framing the time at which income is recognized. The GAAP model tells accountants when to list an income in the financial statement so that it doesn’t mislead external parties. The IFRS (international financial reporting standards) is another body of accounting guidelines followed outside of the U.S.
When Does A Business Need To Be Conscientious Of Revenue Recognition?
While all businesses need to keep necessary tabs on cash flow, revenue recognition applies the most to businesses that are paid upfront for a project. When you collect money from clients contractually, you must follow certain guidelines before revenue reporting. Here’s a list of some businesses that must seriously consider revenue recognition:
- Businesses that provide subscriptions including software companies, membership websites, publications, and so forth
- Contractors and contract-based businesses that receive payments upfront
- Retainer-collecting professionals
Common Revenue Recognition Examples
- If you’re a subscription business: Imagine a Seattle-based publication company that issues weekly magazines for an annual subscription of $250. How will the company recognize its income? Even as it receives the full $250 payment, it’ll only list $21 as its monthly earnings. This is because a possible subscription cancellation will result in that company owing money back to the canceled customers
- If you’re a contractor: Let’s say you’ve received a hefty amount for running an ad campaign over your YouTube channel for two months. Once again, when listing income, you’ll be required to divide the amount by two and recognize the quotient as your monthly earnings
Where Does Deferred Revenue Fit Into The Conversation?
The term deferred revenue applies to the money that’s collected but not earned. It’s also known as ‘unearned revenue’.
Don’t get carried away by this term. Unearned revenue is the money that you owe to the customer. This is why it’s always classified as a liability by the accountants. Here’s what you must do.
- In case you’re a subscription business, any payment collected at the beginning of the year will be completely listed as a liability. This amount listed as liability will reduce progressively once you begin earning this revenue
- Your accountant or bookkeeper must list out the income you earn one month at a time
- The practice is crucial to gain the trust of prospective investors who wish to see all of your liabilities marked clearly
How To Handle Revenue Recognition While Following GAAP Principles?
The Financial Accounting Standards Board (FASB) made certain changes to the GAAP guidelines in 2014. The new set of guidelines is called ASC 606. The guidelines allow businesses to line up their financial statements for an improved comparability check between them. The FASB also modified the disclosure requirements in revenue reporting, which means you might be required to disclose some extra information to prospective investors.
While following the new ASC 606 guidelines, businesses must look out for the following steps.
- Draw up lucid terms in the contract with your customers. You must spell out the services you provide or the goods you deliver to your customers. Avoid fine-printed terms and conditions. Most importantly, be honest in drawing up a contract
- Sort out your obligations as a service provider. You might be required to deliver more than just one service/good. List each service and what it’ll charge separately. For example, in the case of the magazine subscription business, any additional service such as a monthly magalog must be listed separately
- Calculate the cost of all services included. Once you list all the services your customer asks for, determine the total cost of the transaction. This practice is called expense recognition. You must inform your customer about the total costs involved
- Break down the obligations in terms of the associated price. List down the cost of each service separately. For costs that you’re unsure about, simply list the estimates
- Start recognizing revenue upon delivering each service separately. Finally, start recognizing the services listed separately in your revenue recognition report
You must take care to note that unless you’re a SaaS business (software as a service), the modifications won’t affect you drastically. SaaS businesses have had to deal with enormous inconsistencies before. This is because they supply multiple services as part of a single plan. With the new guidelines, businesses of all kinds can ensure a much more transparent financial statement for future investors.
Revenue recognition is an important ethical aspect of your financial statements. Greater transparency in your business will almost always score you greater reach. Make sure to familiarize yourself with FASB’s modified set of GAAP guidelines before you start drawing up your financial statements to attract investors.