Revenue recognition is the process of allocating revenue to a specific time frame based on when the business earned (not received) the revenue.
Let’s say you run a lemonade stand. Every cup of lemonade is delivered at the time of purchase, so your lemonade stand’s revenue recognition is immediate. You sell it, you earned it—plain and simple.
But not every business runs on instant gratification. Maybe you’re a personal trainer who sells blocks of training hours, or a house-cleaning service that runs on a subscription basis. Customers pay up front while their usage of your products and services are staggered, which means your business hasn’t technically “earned” that lump-sum revenue.
Revenue recognition is the exercise accountants and business owners go through to match delivered goods and services to earned revenue. A personal trainer may sell packages of 20 hours of training for $2,000 and then agree to 4 hours per month with each client. As each month goes by and 4 hours of training are completed, $400 in revenue is recognized.
How Does Revenue Recognition Relate to Cash vs. Accrual Accounting?
For our lemonade stand, a product sold is a product delivered. This type of business model is optimal for cash basis accounting, which recognizes revenue and expenses as soon as the business receives funds and pays the bills, respectively.
Cash basis accounting functions much like a personal checkbook ledger (or reviewing your online bank account balance). When a payment comes in or a check is cashed, the bank records it on your account. There’s no judgment required regarding how an amount of revenue is recognized. It just happens.
For those businesses running on accrual basis accounting, the business records both revenue and expenses when it earns them, regardless of when the check (or bill) comes in the mail. This process might seem like extra work, but it also has benefits: accrual accounting can help business owners project income and expenses out into the future. Cash accounting only tells you what’s happened up until this point.
Why is Revenue Recognition Critical to Accrual Accounting?
The process of recognizing revenue is imperative to businesses that use accrual-based accounting because there are significant risks involved. A customer could pay for a monthly subscription of house-cleaning services and make a one-time, upfront payment. What if that customer comes back after 6 months and wants to cancel? If the business owner has already recognized (or even spent) all of the revenue, they’ll have to go back and take it off the books – and explain why.
Revenue recognition empowers business owners to allocated earned revenue over time, and keep any unearned or deferred revenue (that’s revenue that hasn’t been recognized yet) in a separate category. In a way, revenue recognition allows the business to ignore that they have the unearned or deferred revenue, so they don’t make any decisions based on funds that could be relinquished.
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Where Does Unearned or Deferred Revenue Live?
Unearned or deferred revenue should be classified as a liability in a business’s accounting records so it shows up in the liabilities section of the balance sheet. As the business delivers products and services and recognizes revenue, that unearned or deferred revenue will transfer over to an asset.
For our house-cleaning service, all of the incoming revenue (let’s say $3,000) is categorized as a liability initially. Each month as cleaning service is rendered, $250 is moved over from unearned or deferred revenue to recognized revenue. This process continues until the business delivers all products and services and recognizes all the revenue.
Unearned or deferred revenue not only keeps the business from spending funds that it didn’t technically earn, it also makes investors and other outside parties aware of how much cash the business is holding that’s not recognized. A large chunk of unearned or deferred revenue can have multiple indications though. Some investors may see a healthy subscription model that should have significant unearned revenue; others may question the business’s ability to deliver on its products and services.
How Does Revenue Recognition Apply to GAAP Accounting?
Recognizing revenue in an accrual-based accounting business isn’t just a process that protects the business from risk and ensures transparency. For businesses (like public companies) that are obligated to adhere to Generally Accepted Accounting Principles (GAAP), it’s a requirement.
GAAP provides a way to standardize accounting practices across a wide variety of industries and business types. This makes it much easier for an outside party to review a company’s financial statements. They look similar and the rules apply across the board, making financial reporting more transparent overall.
However, the rules for revenue recognition as it relates to GAAP have changed a great deal in recent years. The governing body of GAAP, the Financial Accounting Standards Board (FASB), rolled out a new set of revenue recognition rules in the form of ASC 606. These rules went into effect for all GAAP-based accounting businesses in January of 2019.
And make no mistake: the changes to GAAP revenue recognition are positive. Before the changeover, GAAP revenue recognition requirements were industry-specific. A media company would recognize revenue based on licensing fees, where an automotive business would apply the same revenue recognition rules to differing sources of revenue (like rebates and product warranties). Imagine the complexity of an outside investor trying to compare the financial health of businesses in 3 industries—a nearly impossible task!
While GAAP only affects American companies, a similar change was also implemented by the International Accounting Standards Board (IASB), which governs accounting practices for international companies. IFRS 15 details the new requirements for IASB-compliant companies, similar to ASC 606. With both of these changes, recognition of revenue is now treated similarly across the globe.
What Does the GAAP Revenue Recognition Principle Require?
With ASC 606, the same general principles for revenue recognition apply to all businesses.
Here’s what it all boils down to:
- Make sure there are clear obligations in each customer contract. That includes what products and services the business will deliver and customer payment terms. Our house-cleaning contract includes standard house-cleaning, restocking of supplies, and deep cleaning, and requires payment in full to begin the subscription.
- Review every individual item the contract stipulates for delivery. Maybe your house-cleaning contract includes 2 cleanings per month for 12 months, restocking of cleaning supplies 4 times per year, and 2 separate deep-cleaning sessions per year.
- Find the total price for all items in the contract. Locate the total due from the customer for everything your business agreed to deliver – $3,000, in the case of the house-cleaning contract.
- Decide on a price for each item in the contract. If our annual house-cleaning contract is $3,000 per year, maybe that means each cleaning is $100, restocked supplies are $25 each, and the deep-cleaning sessions are $250 each. Name your price.
- Recognize revenue as your business delivers products and services. If you take payment upfront, all revenue will likely go into the unearned or deferred revenue category. Then in the first month, the business performs 2 cleanings and 1 restocking of cleaning supplies. That means $225 would move from the unearned or deferred revenue bucket to recognized revenue for that month.
Do I Really Need to Worry About Revenue Recognition?
Whether or not you need to recognize revenue depends on several factors. If your business runs on cash-based accounting or it won’t be pursuing outside investment, you might feel free to skip the process of revenue recognition.
However, if you’re looking for a loan or other infusion of cash and/or your business runs on upfront payments, adhering to GAAP and applying the revenue recognition principle makes sense. It will protect your business from financial risks and make it easier for outside parties to evaluate the financial health of your business.
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