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Revenue Recognition: What You Need To Know
Published on Friday, April 16, 2021
Without thinking about revenue in some way or another, many business processes will be unfulfilled. For some businesses, it may be easier to know how much revenue is being earned. However, for those who have subscription-based or contract-based businesses, it may be a bit more difficult. Figuring out how much revenue is coming into your business is called revenue recognition.
There is a lot to know about this process. But, it’s important to do because revenue recognition plays a role in successfully and accurately making forecasts.
So with that in mind, this article will give you a rundown on everything you need to know about revenue recognition.
To avoid any confusion later on in this article, let’s first clarify what revenue itself is. To put it simply, revenue is money brought into an organization through its sales. It is the total income before the deduction of expenses. As such, it is not the same thing as income. Your revenue amount can be located on the top line of your income statement and balance sheet.
A Definition of Revenue Recognition
Revenue recognition is the process of understanding when your organization really made the revenue that was earned. It is a GAAP or generally accepted accounting principle, which lays out the requirements that allow revenue to be recognized and states how to interpret it. In general, revenue gets recognized when a critical event occurs, and when the incoming amount is easy for the organization to judge.
To put it differently, revenue recognition encompasses all the prerequisites that a company needs to fulfill in order to recognize a sales transaction as revenue. You must perform revenue recognition such that it relatively accurately reflects the exchange of products or services with the amount expected to be paid for these items.
Revenue recognition is not to be confused with revenue realization.
Deeper Into An Understanding Of Revenue Recognition
It is relatively common for organizations to work in grey areas so as to increase their revenue figures. This is because it makes their company look more valuable and this increases stock prices and draws in investors. This happens most often when the total amount of revenue for a job is not yet collected.
This is why it is generally accepted that revenue recognition should be determined in the same way for all companies in an industry. Revenue recognition policies ensure that those trying to work in grey areas to increase their figures cannot overstate how well their business is doing. It also makes it easier to compare businesses in the same industry.
It is worth noting here that businesses should also keep their revenue recognition practices the same as time passes. This allows for an easier process of historical comparison, for example, when looking at and comparing financial statements historically. It also allows for trends to be reviewed.
So how does the revenue recognition principle ensure that organizations are managing the recognition of their revenue similarly? Well, it necessitates that revenues are recognized on the income statement only when it has been earned and realized, not when the money itself is acquired.
For it to be realizable, the products or services must have already been received by the buyer, even if the payment is only expected later. And earned means that the offering has been provided to the customer. Another thing to remember is that in order for something to be included in your statement, the job must be totally or essentially finished, or it cannot be included.
A final rule is that you have to be fairly sure that the payment for your offering will be acquired, and you must report the revenue and its matching costs in the same accounting period.
Importance Of Revenue Recognition
To a certain extent, organizations are judged according to the amount of revenue that they report. As such, a reported decline in revenue often leads to shares being sold and market value dropping. Conversely, an increase in reported revenue is likely to dramatically increase the number of investors being drawn in and to an increase in stock price.
It is also important to do for the purposes of forecasting and because regulations require that it be done.
Who Should Participate In Revenue Recognition?
If we’re being totally honest, all businesses should have some concern about revenue recognition. However, it is most important for organizations who receive payments immediately, before really earning the money.
For instance, if you have a business that is subscription-based, your customers are paying you before you fulfill your side of the deal. Similarly, if you are a contractor who has been compensated for a project at the beginning of the project, rather than at the end when the work is done, then you have one of the types of businesses that revenue recognition is important for.
In 2014, a new standard was introduced, in terms of revenue collected through contracts. This standard is called the ASC 606 – or Accounting Standards Codification 606. Essentially, it supplies a general framework that businesses must use to recognize revenue from contracts with customers.
Rather than being specific to individual industries like the previous framework, this newer one fits all industries, thus resulting in fewer differences between policies and increasing transparency. It also makes it easier to compare statements of different companies, even if they are in different sectors or industries.
The Process Of Revenue Recognition
So now that you have the definitions and all the relevant background information, let’s look at how to go about the process of revenue recognition. There are 5 main steps that you need to follow in order to successfully complete the process. We have listed and detailed them below:
1. The Contract And The Customer
First, you need to match the contact to the individual buyer. In most exchanges, there is a formal contract that states how much you will be paid for your services or goods. Even if there is no written contract, there would have been a verbal agreement on the terms of the exchanges.
2. Identify Obligations
Using the contract, make note of any performance obligations that are required from you. You must be very clear about what your obligations are. It is important becomes revenue can only be recognized if the customer has received the goods or services that they purchased from you.
3. Figure Out The Price For The Exchange
Here you must determine the price for the transaction. It is the amount that the customer needs to pay in order to receive the products or services. This amount is not inclusive of any other amounts collected.
4. Connect The Transaction Price To The Performance Obligations
The next step is to take the amount that you determined in the previous step and allocate it to the performance obligations that you identified in step 2.
5. Recognize Revenue
Once you have ensured that your performance obligations are completed (in other words you have carried out your side of the exchange) then you can recognize revenue. Remember, as we mentioned earlier, the revenue is able to be recognized once the customer is in possession of the goods or has been provided with the services.
Before actually recognizing revenue on your statements, ensure that you have followed all the steps in this article and that you understand the intricacies of the practice. Doing it incorrectly can affect your forecasts, your ability to attract investors, and much more. It is a very important task, so make sure you’re doing it carefully!