Last editedAug 20222 min read
What are the different revenue recognition methods?
There are a number of ways in which income can be recognised as revenue on a business’s financial statement. The revenue recognition method used depends upon the industry and business type. In this post we’ll ask, “what is revenue recognition” and illustrate the various ways in which companies can record their revenue.
Revenue recognition definition
Revenue recognition is a “generally accepted accounting principle” or GAAP, that refers to how a business organises, and accounts for, its revenue. It’s a useful way for investors and other stakeholders, who aren’t a direct part of a business, to understand a firm’s financial position.
Revenue recognition should be easy to identify, and a standard format should be used to consistently record transactions. When we’re discussing revenue, it’s important to note that companies don’t always receive payment for their products or services right away. For example, in the case of a subscription-based company, customers may pay before they receive their product. Alternatively, customers may pay for their orders once they’ve been shipped and delivered.
Importance of revenue recognition
Revenue recognition makes it easy to examine how profitable a company is. It also makes it easier to see any losses that have been incurred. Understanding profit and loss margins indicate a company’s ability to balance profits and losses. When these are looked at over time, it’s clear to see how well a business has been doing, and how profits have improved or declined. This gives a view of the overall health of the business so that companies can make changes to improve things.
Correctly recognising revenue is also important in order to ensure that accounting records are accurate for reporting purposes. This can also help a company secure financing because external lenders, creditors and investors can make more informed decisions about whether a company is robust enough to warrant a loan.
Revenue recognition methods
Revenue can be recognised in a number of ways, as outlined below.
Recognised revenue is also termed “earned” revenue. This applies when a business receives cash in exchange for its goods or services. Recognised revenue is recorded as income. For example, a retail store receives its cash at point-of-sale, immediately a customer buys a product from them. In this way the revenue is “recognised” as soon as the money reaches the company’s bank account.
Accrued revenue occurs when a company has provided a good or service, but not received cash for it. It is recorded as a “receivable” because it’s money that’s owed to a company by a customer. For example, a company may provide a service to a customer that takes a year to complete. Alternatively, a customer may place an order for a large volume of items, with the proviso that payment will be made upon delivery.
The money that’s owed to the company is termed accrued revenue. As each item is shipped to a customer, it then counts as earned revenue. Only when all the items have been delivered can all the revenue be considered earned revenue.
When a payment has been made by a customer, but no products or services have yet been provided, this is termed deferred revenue. It is recorded as a liability because it’s still owed to a customer. SaaS companies work on this basis, whereby customers generally have to pay for a new subscription before their current subscription ends.
Subscription companies don’t recognise the full yearly payment as revenue for the month in which it received from a customer. They recognise a part of the total payment each month. If an annual subscription costs £600, the company will record £50 of earned revenue in the first month and £550 as deferred revenue. As the months pass, deferred revenue reduces, as earned revenue increases.
Understanding how to record revenue is a fundamental aspect of the accounting process. To help streamline the process, accounting software like Xero could be invaluable.
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