Published on Tuesday, December 29, 2020
Are you fully realizing all of your sales deals on your income statement? Revenue realization and revenue recognition are two different events that impact your ability to accurately forecast and reflect on the true earnings in a period.
Definition Of Revenue
Before we go any further, let us look at the concept of revenue.
All the money generated from the sale of goods or services by a business is called revenue. For example, in a SaaS company, revenue would be from the sale of monthly or annual subscriptions.
Revenue is different from income, which is a concept on its own but often gets used interchangeably.
Without getting into too much detail, revenue is all income generated without deducting expenses. It is found on the top line of your balance sheet and income statement.
Income refers to a business’ profitability, also known as net profit or net earnings. It is found on the bottom line of the income statement, carrying over to the cash flow statement.
It is important to report revenue correctly in the business, as the company may use the figure to draw in potential investors, apply for financing, or compile financial statements for the shareholders to view.
Revenue Realization vs Revenue Recognition: What Is The Difference?
In a cash business, revenue may be realized immediately as it comes in. However, in SaaS companies, realization is the ratio of how much of a Sales deal or commitment has been recognized as revenue. Essentially, revenue realization is defined as sales converted into revenue.
Where this takes a turn in the SaaS financial model is when a customer signs a sales deal that only gets deployed at a later stage.
As an example, say a deal was sold in January for $1,200. The deal was an annual subscription of $100 per month. However, due to unforeseen circumstances, such a lack of activation caused by vendor delays, for example, the subscription only gets deployed in April, and not in January. This means that by the end of the year, the company has only realized $900 of the projected $1,200 – translating to a realization of 75% of revenue.
To work around this and produce more accurate financial reports, revenue recognition is recorded. Based on the accrual accounting method of deferrals, the booking is recognized as soon as the sale is made, regardless of whether the money and/or services are realized. Effectively, the revenue is deferred and not yet realized.
Why Recognize Revenue?
The short answer is for forecasting and regulatory purposes. Because the money is not yet realized, it is estimated through revenue recognition. As a process of recording revenue, recognition is continuous. Realization is the point when recognition ends. The former is precise and accurate, while the latter is an estimate.
For companies deferring revenue, this is important for accurate forecasting.
As an example, a SaaS company that bills $1,200 annually can’t recognize that as revenue yet. The customer might fail to pay, downgrade, or cancel their contract.
Simply omitting the figure from the financial statements is not accurate either. It doesn’t provide any insight into the future for planning purposes or lend towards securing loans or assessing business performance against targets.
The Accrual Accounting Method and Deferred Revenue
To remedy inaccurate health views, in our $1,200 annual subscription, $100 is recognized monthly for the 12 months.
Similarly, you would record associated expenses on a pro-rata basis to report them in the same month of the recognized revenue.
This provides a more accurate overview of the financial health of the business.
And what happens to the remaining deferred $1,100 of the subscription value? It shows as a liability on the balance sheet.
Where companies have to be careful is to acknowledge that the principle of recognition is an approximation. It does not necessarily provide a consistent basis on which a company can evaluate its performance over an accounting period; there may be fluctuating cash flow.
Furthermore, even with money in the bank account, high deferred revenue on the balance sheet won’t point to a healthy financial status. This will be impacted by your team selling annual or monthly subscriptions.
Conditions Under Which Revenue Is Recognized
The accounting industry has identified four conditions that must be met before revenue can be considered recognized. These are arrangement, delivery, price, and collectability.
Arrangement, the first condition, dictates that there needs to be an agreement between two parties in a transaction. Most businesses have a standard procedure for sales, like a client signing a contract or filling in an order form.
Businesses and clients need to adhere to the standard procedure before they can recognize revenue. Of course, the best evidence of an arrangement is a client paying cash for goods or services.
Businesses meet this condition when they deliver a product or service to a client. They cannot recognize revenue until the client receives what they pay for. For example, if a client signs up for an annual subscription from your SaaS business, you need to see out the year and deliver the software service in full before declaring the sale as earned revenue.
The third condition, price, states that the seller needs a fixed price. The transaction needs to match the amount of recognized revenue. If the price is $40, the recorded revenue needs to be $40. There cannot be any contingencies that affect the sales agreement.
Furthermore, if there are conditions included in the sales agreement, for example, the client being able to cancel the sale, a business can only recognize revenue after the expiry of that condition. However, if customers have the right to a refund, a business could recognize that revenue, but the business needs to include an allowance for the refund.
Collectability, the fourth condition, is a business’ assurance that a client will pay for goods or services. They need to ensure that any recognized revenue is from a client that has a history of timely payments.
If a client has no history, businesses need to hold off recognizing revenue until the client pays. And if a trusted client does not pay on time or at all, the business needs to write off the revenue as bad debt on their next financial statement.
What is Revenue Realization?
Revenue realization is the ratio of recognized revenue vs. total sale amount. For example a SaaS company selling $10,000 of SaaS software services, that were cancelled midway through the year, may only recognize $5,000 of the total $10,000, hence a 50% realization. Or the actual recognized revenue may be based on utilization of a service, which may or may not occur at anticipated levels. Here is a typical formula for revenue realization:
(Amount of Actual Sale)
As you can see, this is quite different from recognizing revenue, and helps your business in a different way, by giving you different (although very relevant) information.
SaaS businesses use the accrual-basis accounting method to differentiate between revenue realization vs revenue recognition. There are specific terms they have to meet before the figures can be counted toward contributing to the bottom line. Knowing what these are gives the business a better overview of its actual health along with projecting it to plan for the future.
If you need better insights between your closed deals and actual revenue, then contact us for a demo on our platform. Get a full view across your CRM and financial applications for a single point of truth and automatically generated associated revenue plans.