Throughout the sales process, there are many different points when your business could recognise revenue.
So, at what point do you need to mark down “cash” as “revenue” in your accounting books? After delivery? When you receive the order?
That’s what the revenue recognition principle – which has become increasingly crucial after IFRS 15 and ASC 606 – can help you to understand. What is the revenue recognition principle?
Why is the revenue recognition principle needed? Explore all that, and more, with our guide to revenue recognition.
Understanding the revenue recognition principle
In a nutshell, revenue recognition is an accounting principle that “cash” doesn’t become “revenue” until you’ve delivered the product/service. This is because up until that point, the customer can ask for a refund. If you’ve already spent the money, that’s a big problem, and it can lead to significant issues with your company’s accounts. As such, it’s vitally important to pay attention to revenue recognition.
When a product is sold, paid for, and delivered in short order – as with e-commerce companies – revenue recognition isn’t such a big deal. However, revenue recognition can get much more complicated if you’re running a subscription business. Think about it. Even if your customers pay upfront for an annual subscription, you can’t mark the payment as revenue because you haven’t delivered the service in full. So, how and when do you recognise the revenue? Let’s find out.
How does revenue recognition work under ASC 606?
Until relatively recently, there hasn’t been a standardised revenue recognition process. The introduction of IFRS 15 and ASC 606 has changed all that, providing businesses with a consistent framework for reporting revenue. Although these compliance standards can be a little complicated, they boil down to five basic steps, which are as follows:
Identify the contract with the customer – Firstly, you need to ensure that the agreement, or contract, that you have with your customer spells out what goods/services you’ve agreed to deliver, as well as the payment terms for those goods/services.
Determine the performance obligations of the contract – Next, you need to confirm all the obligations stipulated in the contract. Usually, this refers to the provision of specific goods/services, but it can also cover discounts, bonuses, credit, etc.
Identify the total transaction price – Now, you’ll need to ensure that the contract states very clearly how much the customer will be charged for the goods/services you’re providing.
Match the performance obligations to the transaction price – Then, you’ll need to break down the cost of each good or service that you’re delivering. SaaS businesses have a continuous performance obligation, so you’ll need to allocate a share of the total transaction price to each month or billing period.
Recognise revenue upon delivery – The final piece of the puzzle is to make sure that you’re recognising revenue only after the fulfilment of each performance obligation. So, when does a performance obligation become fulfilled? There are five essential criteria: the risks and rewards have been transferred to the seller, the seller has no control over the goods being sold, the collection of payment has been assured, the amount of revenue can be measured, and the cost of earning that revenue can be measured. At this point, the ASC 606 revenue recognition conditions have been met, and you can count your billings as revenue.
Why is the revenue recognition principle needed?
The revenue recognition principle has several important benefits. Firstly, it provides you with real-time insight into your company’s profit and loss margin. This means that you’re always getting the most accurate reading on your business’s financial health. By ensuring the credibility of your accounting records, you can continue making financially-sound decisions, maintaining a steady balance of revenue and expenses. Since financial stability is a significant factor for investors, the revenue recognition principle may also be relevant for companies seeking financing.
We can help
GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.