Last updated on Tuesday, December 29, 2020
Revenue realization and revenue recognition are unique but related concepts. Learn the difference between them and how each impacts your business’s ability to accurately forecast revenue and measure true earnings.
Revenue realization occurs when revenue is physically collected by a company. In other words, a sale could be made at any time, but the revenue isn’t realized until payment is received.
Revenue realization plays a critical role in accurate revenue and profit reporting. If sales bookings are reported as revenue, you run the risk of overreporting revenue and making business decisions on an inaccurate cash flow assessment.
A SaaS company sells an annual subscription for $100/month in January. Due to vendor delays, the subscription isn’t deployed and activated until April. According to the sales forecast, the company should receive $1,200 in revenue by the end of the year. But in reality, only $900 was received. In this example, 75% of the revenue was realized.
Revenue recognition is the process of recognizing revenue in financial statements when a sale is made, even if the customer has not yet paid. The principle is based on the accrual accounting method of deferrals and is used to ensure financial reports remain accurate, even when revenue isn’t yet realized.
For companies deferring revenue, revenue recognition is important for forecasting and regulatory purposes.
When revenue is deferred, you can’t simply omit it from your financial statements. You need to account for it in future planning and business performance analysis. Revenue recognition ensures that deferred revenue doesn’t slip through the cracks, but is properly documented and reported in your annual income statement.
Revenue recognition can only occur if specific conditions are met.
The accounting industry has identified four conditions that must be met before revenue can be considered recognized: arrangement, delivery, price, and collectability.
Arrangement dictates that there needs to be an agreement between two parties in a transaction. Most businesses have a standard procedure for sales. For example, a client must sign a contract or fill in an order form.
Businesses and clients need to adhere to the agreed standard procedure before they can recognize revenue.
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.
This condition states that the seller needs a fixed price. The transaction needs to match the amount of recognized revenue. For example, if the price is $100, the recorded revenue needs to be $100. There cannot be any contingencies that affect the sales agreement.
If there are conditions included in the sales agreement (e.g.the client may 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 they need to include an allowance for the refund.
Collectability 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.
SaaS businesses use the accrual-basis accounting method to differentiate between revenue realization and revenue recognition. There are specific terms that must be met before the figures can be counted toward contributing to the bottom line. Knowing what these are gives your business a more accurate assessment of business health and enables future planning.
If your business is struggling to see the gap between closed deals and actual revenue, request a demo of revVana using the form below. Our Salesforce-native application gives you a single source of truth for sales bookings, revenue recognition, and revenue realization, and empowers you to automatically generate accurate revenue plans for proactive business planning.
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