While not all businesses are required to comply with the revenue recognition principle of accounting, it’s an extremely useful concept to get to grips with.
Revenue recognition provides the most accurate picture of the financial health of your business. It can also be useful for understanding your market position in relation to competitors and can serve as credible evidence of sound finances when seeking investment.
In this article, we explain what revenue recognition is, why it’s important, the key requirements and the 5 steps of revenue recognition, and how Checkout.com can help your business with its revenue recognition needs.
Revenue recognition is an important accrual accounting principle that outlines when and how a company should record revenue on its financial statements.
In theory, revenue is recognized once it has been earned, not when you have received payment from the customer. This accrual-basis accounting method is distinct from cash-basis accounting, which recognizes the money at the point of receipt.
The term ‘earned’ can be a slippery one. In a broad sense, your business has earned revenue when it has fulfilled its obligation to the customer, regardless of whether you have received payment. E.g. when they have received and benefitted from your product or service. However, the point at which an obligation can be considered fulfilled is not so clear cut, which means revenue recognition standards can vary by region and sector. For example, some companies deliver their products or services over an extended period of time, meaning fulfillment can be delayed.
In the US, according to the revenue recognition principle of ASC 606, revenue should be recognized when the delivery of promised goods or services matches the amount expected by the company in exchange for the goods or services. We’ll go into more detail about this standard and what it means for your business below.
Proper revenue recognition is important because it translates directly into accurate accounting. This prevents companies from cooking their books and gives investors, analysts, and regulators a credible picture of the financial health of your business.
A number of organizations exist to guarantee the consistency of revenue recognition standards across international markets, sectors, and business models, including the International Accounting Standards Board (IASB) and the International Financial Reporting Standards (IFRS).
As an accrual-basis accounting method, revenue recognition is most suitable for businesses with certain business models. Likewise, some business models present interesting case studies for when and why revenue should be recognized.
Here are some common types of revenue recognition:
A digital subscription business gives customers consistent access to a service in exchange for a fee paid on a timeframe that works for them - e.g. annually or monthly. As the service is delivered continually, subscription businesses can recognize revenue as each month of the customer’s contract is fulfilled. Revenue received in advance of a month of delivery should be recorded as deferred until the month of access that the customer has paid for has elapsed.
However, you also need to account for upgrades, downgrades, and cancellations. For example, if a customer decides to upgrade from the basic plan ($10 per month) to the premium plan ($20 per month) on September 15th, revenue recognition has to be adjusted to account for this difference. That means they would have derived $5 of value from the basic plan and $10 of value for the premium plan within the month, so you would recognize $15 in revenue for September.
What about a company that charges a recurring monthly subscription fee to deliver weekly recipe boxes to its customers? In this case, revenue would be recognized proportionally when each weekly shipment has been delivered. So, if the monthly fee costs $60, $15 would be recognized each week.
A contractor's payment terms and timeframes can be complex. For example, let’s take a building contractor who’s undertaking an office renovation for a business as an example.
They may split the cost of the job into separate payments as a percentage of completion according to an agreed schedule: 40% up front, 30% at the halfway mark, 25% one week before completion, and 5% two weeks after completion.
As each milestone is reached (and subject to each obligation being fulfilled on time), the contractor updates their ledger to recognize the revenue, even if they haven’t actually been paid. The performance obligations have been fulfilled, so the revenue is recognized.
Unlike the traditional bricks and mortar retail model, ecommerce customers don’t receive their goods the moment they purchase them, but your business does receive the money. You could decide to either recognize ecommerce revenue when you have shipped the goods (as recommended by ASC 606 and IFRS 15) or when they have been delivered (the rule for ASC 605).
Publicly traded companies in the US are required to comply with Generally Accepted Accounting Principles (GAAP) revenue recognition standards.
Private companies are not legally bound to meet these standards. However, if you’re seeking finance, you may find that banks and investors prefer GAAP-compliant financial reporting or even make it a condition for investment.
The IFRS also has its own criteria for revenue recognition that publicly-traded companies are required to follow. Again, many private companies in regions overseen by IFRS also choose to meet these standards.
Simply put, cash accounting recognizes revenue and expenses when you receive payment and accrual accounting recognizes revenue and expenses when they are earned, regardless of whether you have received payment.
For example, under cash accounting, a company that receives $,5,000 for a shipment of goods on September 5 would record the sale as having occurred on September 5, even if they have yet to ship the products. In contrast, under accrual accounting, the $5,000 revenue would be recognized when the goods have been shipped or delivered, regardless of when the business actually receives payment.
Cash accounting is a more straightforward method of accounting to understand, though it’s less accurate than accrual accounting in the short term. That’s because, by recognizing revenue when you have received payment but before you have fulfilled an obligation, you may not factor in any liabilities incurred, which risks overstating the performance of your business. Likewise, you may have fulfilled your obligations but not yet received payment, which understates the performance of your business.
Accrual accounting provides a clearer picture of performance by matching expenses and revenue to fulfillment of obligations.
In 2014, the FASB and IASB jointly issued Accounting Standards Codification (ASC) 606. This update aimed to improve on existing guidance around customers contracts and to standardize the revenue recognition process with an industry-neutral five-step framework:
The first step is to identify the contract or contracts with your customer. This could be either a verbal contract or a formal written agreement. Contracts should clearly state each party’s rights, payment terms, the delivery of goods and services, and the consequences if either party doesn’t fulfill their obligations.
Contracts can also take the form of a receipt from a bricks and mortar store or, for an online purchase, an invoice or subscription details.
Next, you need to identify the performance obligations, which is a promise to deliver a ‘distinct’ good or service to your customer.
A good or service qualifies as distinct if the customer can benefit from it either independently or in combination with other resources on a contract. It must also be identifiable as separate from other contractual promises. That could mean it is clearly stated as one line for a set price on a receipt.
As well as the fixed amount received in exchange for goods and services, the transaction price should include discounts, return policies and additional fees. These terms should always be transparent as it's important to recognize the possibility of chargebacks or refunds and their impact on revenue. However, the transaction price does not include amounts collected on behalf of third parties like sales tax.
Other factors can influence the determination of transaction price, including if there is a chance for market volatility to affect revenue, if there is a financing component to the contract, if the customer uses a non-cash method of payment, or if the company must also make some kind of payment to the customer.
If the contract contains more than one performance obligation, you must determine a specific selling price for each one.
Finally, revenue should only be recognized as each performance obligation is fulfilled. For example, when you have transferred control of the good or service over to your customer or, in the case of a subscription business, revenue should be recognized evenly throughout the service period. In other scenarios where a service is provided over time, you may recognize the revenue as targets or milestones are met (as in the contractor example above).
The IFRS revenue recognition criteria stipulates three conditions that must be met for contracts to exist. They are:
GAAP revenue recognition criteria are based on FASB guidance and conform to the revenue recognition principle of accrual accounting. In other words, revenue should be recorded on your income statement when it is earned - that is, when your obligation to deliver the product or service to the customer is complete - and not just when payment has been received.
Additionally, according to the matching principle, both revenue and associated expenses must be reported in the same accounting period.
Revenue recognition helps your business in a number of ways, including:
Checkout.com offers a number of tools and services that can help businesses with their revenue recognition process.
Firstly, we provide detailed transaction data and real-time reporting, as well as an automated reconciliation tool, which makes it easy to get an accurate picture of when revenue has been earned and to match it to your expenses.
Subscription businesses can use our recurring payments solution to streamline revenue collection and to manage customer accounts when they are upgraded, downgraded or canceled.
Best of all, whether your business is subscription-based or an ecommerce fulfillment operation, we support your global expansion by allowing you to offer dozens of payment methods, transactions in more than 150 currencies, and local expertise and acquiring.
Discover how Checkout.com can help with revenue recognition or speak to a member of our sales team.