Revenue Realization

What is Revenue Realization?

Revenue realization is the process through which a company collects revenue from its sales or services in accordance with accounting standards (e.g., GAAP). It’s a crucial aspect of financial reporting, as it affects a company’s profitability and cash flow.

As an example, let’s say a company sells a product for $100 and receives payment immediately. In this case, the revenue is realized at the same time as the sale. If, however, they received payment in installments over a period of time, the revenue would only be realized as each installment is paid.

This highlights their importance when considering bookings vs. revenue. If you report sales bookings as revenue, you risk overstating your revenue for that accounting period and basing business decisions on an inaccurate cash flow assessment.

Synonyms

• Revenue realization principle
• Realized revenue

The Revenue Realization Principle in Accounting

Realization is required to report on financial performance and make accurate revenue forecasts. You have to know which revenue has been earned and can thus be reported on the income statement for a specific accounting period.

Revenue realization vs. revenue recognition

Revenue recognition is the process of recording revenue on a company’s financial statements. Revenue realization, on the other hand, is when that revenue is actually collected and recognized as income.

• Revenue recognition is focused on accrual.
• Revenue realization is about cash flow.

The revenue realization principle is based on the revenue recognition principle — that is, that revenue is only recognized when it has been earned, regardless of whether payment has been received or not.

To recognize revenue, a company must meet specific criteria:

• Arrangement: There is a clear agreement between the buyer and seller.
• Delivery: The goods or services have been delivered to the customer.
• Price: The selling price is fixed and determinable.
• Collectability: The seller is reasonably assured they’ll collect payment.

This is particularly important to distinguish if your company deals with deferred revenue. Consider an example of a SaaS company selling a $100/month subscription:

• The company recognizes the revenue at the end of the month, when the month’s worth of access has been fully delivered to the user. Before that, it’s unearned revenue.
• They realize this revenue immediately, though. The customer pays for the subscription upfront, and when that payment hits the company bank account, it becomes part of the cash flow.

The revenue recognition process

For businesses using accrual-basis accounting (which is any company that’s doing more than $25 million in sales per year or is publicly traded, plus thousands of smaller ones) ASC 606 compliance is mandatory.

To comply with ASC 606 (or, for international companies, IFRS 15), you have to recognize revenue according to a five-step process:

Understanding the revenue realization rate

You’ll always have deals you forecasted and booked in your pipeline that wind up being less valuable than you previously expected.

Let’s say you’re a B2B manufacturer and had a customer who agreed to purchase $10M worth of goods over the course of a year. But a complication happened and they could only purchase $9M.

This is where realization comes in. Your revenue realization rate is the amount of revenue you actually recognized on fiancial statements compared to what you initially expected. You can also look at it as the total amount billed vs. the amount that was forecasted to be billed in the original sale.

To calculate it:

In the example above, your revenue realization rate would be:

You can use your realization rate in revenue forecasting by taking an average. If you find your average realization rate over X number of transactions is 90%, then it’s reasonable to expect that any future transactions will also be around 90%.

When you look at realization on a case-by-case basis, it also helps you understand where you’re leaving money on the table. If you have reps who consistently close below the average realization rate, for instance, you can work with them to fine-tune their sales process.

Calculating the Realization of Revenue

Calculating the exact amount of revenue you’ve realized can be done using different methods depending on the nature of the contract or sale.

Here are three common methods:

Percentage of completion

This method is used primarily for long-term contracts, such as in the construction industry, where revenue is recognized as the project progresses. The percentage of completion is typically calculated based on the costs incurred to date compared to the total estimated costs.

Suppose a construction company has a contract for a $4 million project with an estimated cost of $3 million. If the company incurs costs of $1.2 million by the end of Year 1, the percentage of completion would be calculated as follows:

And the revenue recognized would be:

Completed contract method

Under this method, all revenue and expenses are recorded only upon completion of the contract. This method is a lot more straightforward but can lead to large fluctuations in financial results since revenue is recognized only at the end of the project.

Using the example above, the revenue of $4M and $3M in costs would only be recognized at the end of Year 2 when the project is completed.

Since it’s difficult to predict and plan around these large fluctuations, this strategy is much more common when businesses are dealing with short-term contracts or one-time sales.

Installment method

This method is used when the collection of cash is uncertain. Revenue is recognized as cash is received, which helps to manage risks associated with uncollectible accounts. This is often applied in sales of real estate or high-ticket items where payment is made in installments.

Suppose a company sells a piece of machinery for $60,000, to be paid in installments of $10,000 over six years. Under the installment method, the company would recognize revenue as follows:

• Year 1: When it receives the first $10,000 payment, it recognizes $10,000 in revenue.
• This continues for each subsequent payment, realizing a portion of the profit as cash is collected.

SaaS companies also use a modified version of the installment method when recognizing revenue over the course of a subscription period. 

Let’s say you’ve got a SaaS product and you charge $1,200/year. If that’s billed monthly, you’ll realize $100 each month as the customer makes payments.

Revenue Realization Challenges and Solutions

Here are the biggest challenges we see with revenue realization (and how to solve them):

Mistakes in forecasting

Forecasting future revenue is challenging because you need to rely on historical data and make assumptions about the future. Being off by just a small margin can have a significant impact on your actual realization rate.

Solution: Continuously evaluate and adjust your revenue forecast based on new information, market changes, and customer feedback.

Delayed or non-payments

Sometimes customers don’t pay their bills on time or at all. This can significantly impact your revenue realization rate if it happens frequently.

Solution: Have a clear payment process in place with clear expectations for when payments are due. If possible, automate the billing process so recurring payments are automatically deducted from the customer’s account.

Long-term contracts

Contracts that span over a long period can be difficult to manage and calculate revenue realization accurately.

Solution: Use the percentage of completion method and establish clear milestones for recognizing revenue throughout the duration of the contract. Review and adjust these periodically as needed.

Deferred revenue

Accurate revenue realization is more challenging when you have to recognize the revenue after you’ve received and have possibly already been using the cash.

Solution: Your CPQ (configure, price, quote) or subscription management system should have the capability to manage deferred revenue and recognize it at the right time. If needed, work with your finance team to develop a process for monitoring and managing deferred revenue throughout.

Multiple performance obligations

Contracts with multiple performance obligations, such as service contracts that also include product sales, can be tricky to manage because you need to allocate and recognize revenue for each performance obligation separately. And some of them will be delivered and paid in advance, while others may be paid in installments or service delivery won’t happen all at once.Solution: Use contract management software to define and separate the different performance obligations in your contract. Use specific criteria for recognizing revenue for each obligation and ensure they are accounted for correctly.

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