Glossary > Revenue Recognition

Revenue Recognition

Reviewed By Eyal Orgil -Updated December 28, 2023

In business accounting and revenue operations (RevOps), revenue recognition is the process of accounting for revenue at the time a business earns it.

It is an essential concept in accrual-based accounting, which requires businesses to recognize revenue when earned rather than when cash is received.

What is Revenue Recognition?

Revenue recognition is a critical aspect of financial accounting that determines the specific conditions under which income becomes realized as revenue. It’s the process of recognizing or reporting income as it is earned, essentially matching the revenue from contracts to the expenses related to generating those sales. This ensures that a company’s financial records are accurate and transparent, aiding in decision-making and providing investors with an up-to-date picture of a business’s financial situation.

The Revenue Operations (Rev Ops) team plays a crucial role in this process. They work to align sales, marketing, and finance operations, and ensure the consistency and accuracy of revenue recognition according to company policies and regulatory standards. This coordination helps to streamline revenue strategies, improve operational efficiency, and enhance forecasting accuracy.

On a more technical level, revenue recognition requires adherence to Generally Accepted Accounting Principles (GAAP). These standards are established by the Financial Accounting Standards Board (FASB) and dictate how and when revenue is recognized, reported, and disclosed in financial statements. According to GAAP, revenue can be recognized when it is realized or realizable, and earned. In this context, realizability happens when a company has an unconditional right to receive payment in the future, not necessarily at the moment of payment collection.

Synonyms

Revenue Recognition Principle – The revenue recognition principle is an accounting concept that states that recognition of revenue happens when goods or services are provided and not at the exact time of cash flows. It requires companies to update income statements as revenue is earned instead of waiting to receive payments.
Revenue Recognition Concept – The revenue recognition concept is the basis for determining when to recognize revenue. It requires that revenues be recognized when goods or services are delivered and not at the time of cash receipt, as long as it can be estimated reliably that payment will occur.

Why Revenue Recognition is Important

Revenue recognition has become increasingly complex with the rise of new business models and digital services, particularly in business-to-business (B2B) and Software-as-a-Service (SaaS) entities.

In these types of businesses, the spread of revenue recognition varies due to factors such as customer contracts, payment terms, services delivered, and other considerations.

Revenue recognition is important because it is the basis for business decisions. It helps to identify opportunities and risks, determine pricing strategy, and allocate resources.

Understanding when and how much revenue a business can recognize is key to making accurate forecasts of future performance.

IFRS Reporting Standards Criteria

International Financial Reporting Standards (IFRS) is a set of global accounting standards that companies use to prepare financial statements. IFRS is issued by the International Accounting Standards Board (IASB), an independent accounting standard-setting body.

Compared to U.S. GAAP, which is specific to the United States, IFRS is more principles-based. This means that there is more discretion for businesses in how they apply the standards to their individual circumstances. As a result, there is often greater variation in how companies report their financial results under IFRS than under U.S. GAAP.

A few of the IFRS criteria used in revenue recognition that differ from U.S. GAAP include:

Standing contracts: Under IFRS, companies may recognize revenue at the end of a contract period if certain conditions are met.
Variable consideration: Revenue can be recognized when it is probable that economic benefits will flow to the entity and the amount of revenue can be estimated reliably.
Multiple-element arrangements: Revenue for multiple elements in an arrangement can be allocated based on the relative selling prices of each element, provided that the selling price is determinable and there are no other factors influencing the allocation.

ASC 606

Under ASC 606, the new revenue recognition standard, a company must recognize revenue in an amount that reflects the consideration to which the entity expects to be entitled. This guidance applies to all contracts, including those with customers, subcontractors, and other parties.

In order to comply with FASB ASC 606, companies must identify the performance obligations in a contract (i.e., what goods or services are being exchanged for payment), determine the transaction price (i.e., how much is being paid for those goods or services), and allocate the transaction price to each contractual obligation. The company must then recognize revenue when (or as) each performance obligation is satisfied.

Why FASB Issued a New Standard

There were some issues with the previous revenue standard that ASC 606 was intended to address.

These included lack of consistency in how companies were reporting revenue, a need for more transparency into how revenue is being recognized, and evaluation of whether the amount of revenue being reported accurately reflects the actual value received by the company.

The new standard has been widely adopted and aims to improve transparency, consistency, and reliability of financial reporting during annual reporting periods.

Furthermore, the disclosure requirements under ASC 606 provide more insight into how a company is recognizing revenue and why it may be different from similar companies in its industry.

The Five Steps of Revenue Recognition

According to ASC 606, the revenue recognition process occurs in five steps:

1. Identify the contract with a specific customer

The first step in contract management is identifying the contract with a specific customer. A contract is an agreement between two or more parties that creates enforceable obligations, and it must meet certain criteria to be recognized as a legally binding agreement.

In the case of B2B and SaaS entities, the contract may include details such as pricing, payment terms, delivery dates, key performance indicators, acceptance criteria, and other relevant considerations.

2. Identify the contractual performance obligations

According to the principles of revenue recognition, performance obligations are the goods or services that a company must provide to its customers in exchange for payment.

These obligations may be specified in the contract, or they may need to be determined based on the parties’ customary practice.

When outlining the performance obligations in the contract, companies should consider what good or service is being exchanged for the payment and how it will be provided (e.g., shipping, installation, maintenance).

In order to comply with ASC 606, companies should explicitly state any performance obligations in the contract and provide sufficient detail about each obligation.

3. Determine the transaction price

The transaction price is exactly what it sounds like—the price of the transaction. This includes amounts that are fixed, variable (e.g., discounts), and contingent upon certain conditions (e.g., customer satisfaction).

To determine the transaction price, companies must consider various factors such as pricing models (e.g., consumption-based pricing, success-based pricing, usage-based pricing, subscription business model), discounts, and bonuses.

4. Allocate the transaction price across the performance obligations

Once the transaction price has been determined, it must be allocated to each performance obligation in the contract. This is done by first determining the standalone selling prices of each performance obligation and then allocating them based on their relative values.

One thing to be aware of is that the transaction price may not be allocated evenly across each performance obligation. For example, a customer might pay for one product at a discounted rate but get access to additional services as part of the package.

5. Recognize revenue when the contracting entity fulfills a performance obligation

In this final step, the company must recognize revenue when it has fulfilled a performance obligation.

This does not mean that the company has to receive payment before it recognizes the revenue—rather, it means that the customer must have received what was promised in exchange for their payment.

Keep in mind that the “payment” step does not always happen at the same time as the “fulfillment” step. As such, companies should keep track of customer receivables and be mindful of any possible delays in order to ensure that revenue is being reported accurately.

In some cases, such as with subscription services like Software-as-a-Service, the company may recognize revenue over time as customers receive the specified services.

And since the performance obligations are determined at the time of contract, companies must accurately track their progress in fulfilling those obligations to correctly recognize earned and unearned revenue.