The revenue recognition principle is a guiding principle that helps companies identify when they can recognize and record revenue. When a company makes a sale, the revenue earned must be recorded and correctly reflected on the company’s income statement; the question is when to do this.
Revenue recognition can be less straightforward than it seems because companies can only recognize revenue after it’s been earned. Businesses must understand the conditions under which they can recognize revenue—depending on the accounting system used—to stay compliant and keep their finances in order.
What Is Revenue Recognition?
The revenue recognition principle establishes the process and timing associated with recording and allocating revenue in a company’s financial statements. It is important to have a principle-based system in place because companies can recognize revenue at multiple points in time. Companies typically recognize revenue when a critical event occurs, such as when a product or service has been delivered, and/or when the company can accurately measure the final dollar amount.
Revenue recognition practices are regulated by various financial institutions including the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), and the International Financial Reporting Standards (IFRS) Foundation. These organizations provide the necessary frameworks to help businesses implement accrual accounting systems more consistently and effectively.
Why Is Revenue Recognition Important?
Public companies in the United States must create their financial statements based on generally accepted accounting principles (GAAP). Revenue recognition is one of these principles. Accurate revenue recognition is essential for accurate financial reporting because:
- It prevents companies from confusing income that has and hasn’t been earned
- It allows companies to provide a more accurate picture of their financial health
If you’re a small business or startup, you can show credibility and integrity by following all official guidelines closely. This is especially important when investors or lenders get involved with your business. They will consider revenue one of the most important financial factors when considering the merits of aligning themselves with your business, so it’s of critical importance that you do it right. To ensure accurate and GAAP-compliant revenue recognition, many small businesses opt for outsourced accounting services.
Revenue Recognition vs Cash Collected
These are two related concepts that are important to distinguish. While “cash collected” refers to the moment a business receives funds from a customer (whether or not these funds have been earned), the concept of “revenue recognition” refers to recognizing funds received as income when the funds are actually earned—i.e. when the goods and services purchased have been provided in full.
It’s important to note here that “cash collected” is recorded as earnings when the cash-basis accounting method is being used (whether or not the money has been earned). Revenue recognition only applies when an accrual accounting method is used.
Revenue Recognition Methods
The revenue recognition process can take several forms. Different models may suit different businesses depending on the nature of the business and how and when it charges its customers.
1. Sales-Basis Method
According to this method, you can recognize revenue the moment the sale is made. In a retail store, for example, you could recognize the revenue generated by a customer purchasing an item as soon as they pay the transaction price and leave the store with the item(s) purchased.
This is the most popular revenue recognition method in retail businesses because the purchase process is quick and clear and the revenue can be recognized even if the payment isn’t received immediately (for example, due to credit card processing delays).
2. Installment Method
This method can be used when dealing with large purchases (such as real estate, businesses, and major business assets) when the sale is handled privately rather than through a dealer. Using the installment method of revenue recognition, the cash is collected and recognized as revenue in installments rather than upfront at the time of sale. The installment payments could be spread out over months or even years.
3. Cost Recovery Method
Businesses can use the cost recovery method when collection isn’t certain. This method only allows you to recognize revenue after you’ve received all of the costs associated with the contract. This could be a long time after the contract is completed and the company satisfies all performance obligations.
4. Completed Contract Method
This method allows businesses to recognize revenue when the whole contract is fulfilled and all performance obligations have been satisfied. This method is advantageous to ensure that revenue appears in its correct, corresponding period. It can also prevent issues that occur with the percentage of completion method when businesses can’t recognize revenue due to a lack of clarity surrounding performance obligations. The completed contract method won’t be a viable method if you offer extended warranty periods or have a long-term return policy.
5. Percentage of Completion Method
This method is commonly used with large or long-term contracts. It allows companies to recognize revenue according to certain milestones or stipulated progress indicators. It must be clear in a written contract what constitutes a milestone and when revenue recognition can take place.
Utilizing this method means that you don’t have to wait until the end of a long contract to recognize revenue. Your financial statements will reflect a more consistent and predictable revenue stream with fewer spikes and troughs.
Standards and Principles that Govern Revenue Recognition
There are accounting bodies that set standards for accounting practices both nationally and internationally. The following sections outline the criteria for revenue recognition set by the IFRS (international) and FASB (United States).
IFRS Revenue Recognition Criteria
The IFRS Revenue Recognition Criteria establishes the principles an entity must apply when reporting information about the nature, amount, timing, and uncertainty of cash flows and revenue from a contract with a customer. For accounting periods starting on or after 1 January 2018, IFRS 15 became obligatory for businesses that follow IFRS standards. To recognize revenue according to IFRS 15, a business must:
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- Identify the relevant contract:Agree on the terms, payment and delivery obligations, and consequences if the obligations aren’t met.
- Identify the corresponding performance obligations: Pinpoint any specific goods or services related to the agreement.
- Determine the transaction price: This includes the prices of the goods or services plus other factors like fees, discounts, etc.
- Allocate the transaction price to the contractual obligations.
- Recognize revenue as each performance obligation is fulfilled.
GAAP’s Revenue Recognition Principle
The generally accepted accounting principles (GAAP) are issued and revised by the U.S. Financial Accounting Standards Board (FASB) and apply to all publicly traded companies in the United States. According to GAAP, revenue must be recognized on the income statement in the period that it’s realized and earned, not when the cash is received.
FASB’s ASC 606, Revenue (2014)
ASC 606 is a simplified and universal set of regulations for revenue recognition applicable to all U.S. businesses that make “revenue from contracts with customers.” Essentially, this means that any business that offers customers a good or service is technically subject to these guidelines. These standards are now consistent across all industries, meaning that there are no longer disparities between industries or businesses that use GAAP and those that follow IFRS.
The result of the 2014 revenue recognition update is better transparency, increased accountability, and an easier comparison of financial statements between different companies and industries. According to 2022 research, ASC 606 had a significant impact on how companies recognize revenue due to the requirement to accelerate their revenue recognition. This has shortened revenue cycles from 24 to 18.7 months (page 2 of the PDF).
Important note: The ASC 606 and IFRS 15 offer very similar guidelines and have similar goals but are not entirely the same. An experienced CPA can explain which revenue recognition standards apply to your company and any differences of which to be aware.
Get Revenue Recognition Right
By adhering to IFRS or GAAP guidelines (as applicable), companies can handle revenue responsibly and provide their stakeholders with accurate insights into their financial health. Proper revenue recognition is a large part of this because it impacts your company’s income statement, cash flow statement, and balance sheet.
Companies that present proper financial information can make informed decisions as well as maintain trust with their customers and investors. Outsourcing your accounting—if required—can help you recognize revenue with greater accuracy and ensure compliance with the relevant standards.
