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Revenue is what keeps businesses alive. In turn, accurately recognizing that revenue is one of the most important aspects of running a business.
Both how and when your business recognizes revenue will directly impact the integrity of your financial reporting, not to mention its growth and sustainability. On the surface, this may sound easy, but revenue recognition is no simple task.
Given today’s increasingly complex business models — and the nebulous contracts they involve with various products, services, terms, entitlements, events, payment options and revenue recognition schedules — complications often arise as to when revenue can be recognized. These considerations can make the process of revenue reporting confusing and cumbersome.
Below is a comprehensive guide to understanding revenue recognition and its best practices.
Revenue recognition, explained
What is revenue recognition? Revenue recognition is a generally accepted accounting principle that stipulates when and how businesses should recognize or record their revenue. It requires that businesses recognize revenue in their financial statements only when it’s earned, rather than when payment is received.
Why does revenue recognition matter? Revenue is a crucial indicator of a business’s growth trajectory, illustrating a company’s current standing, performance and prospects to investors and other stakeholders. This makes proper revenue recognition imperative to a business’s financial statements.
What are the consequences of inaccurate revenue recognition? Businesses that fail to recognize revenue correctly in their financial statements risk triggering a ripple effect that may jeopardize long-term success, as illustrated by the five potential consequences below:
1. Incorrect representation of business performance. Inaccurate financial statements make it difficult to analyze business performance, meet investors’ expectations (during due diligence and after the transaction closes) and satisfy bank covenants.
2. Poor operating decisions. Business leaders rely on financial data in budgeting, forecasting and developing KPIs. Inaccurate information in internal reports compromises their ability to make informed decisions.
3. Reputational damage, loss of credibility. Incorrect financial statements can understate profit and make your company look less valuable than it is to investors. It can also hurt brand image, which is especially detrimental for businesses looking to go public.
4. SEC fines, IRS penalties. Revenue recognition errors will likely cause you to overstate or understate profit, leading you to miscalculate your tax liability. If taxes are underpaid, you could be assessed penalties and interest by the IRS, as well as by your state’s tax authority. Additionally, misrepresentation of financial statements can result in SEC fines, legal action and even arrest and imprisonment.
5. Bad data domino effect. Inaccurately recognizing revenue will impact calculations based on your business’s profit figures, such as profit-sharing or investor payouts, potentially landing your business in hot water.
Applying revenue recognition in a business setting
Let’s consider the example of in-home fitness subscription company XYZ Inc. The company charges $50 per month to provide weight training guidance to subscribers.
XYZ also charges a one-time $100 registration fee to learn more about the client’s goals, create a personalized workout plan and send digital exercise equipment. That $100 fee can be recognized as earned.
However, the recurring $50 monthly subscription fee is treated differently. Because this fee is charged to the client on the first of each month, but the workout plan isn’t delivered to the client until mid-month, XYZ can’t recognize the $50 as earned on the first. XYZ hasn’t technically earned it yet.
As our table below depicts, the revenue of $100 is recorded as earned in the accounting ledger because the registration process is complete. But the $50 in revenue must be recorded as deferred because the monthly service hasn’t yet been delivered.
Account (Feb. 1, 2023)
At the end of the month, when XYZ has delivered the monthly workout plan service, the ledger can be updated to reflect the newly recognized revenue.
Account (Feb 28, 2023)
Next, let’s consider revenue recognition for a client who upgrades their plan. An XYZ subscriber who used to pay monthly upgrades to the annual fitness subscription plan, paying for 12 months of the service at a discounted upfront cost of $540 ($45 per month).
XYZ can’t recognize that $540 upfront as earned because it hasn’t delivered the monthly workout plan service yet. Instead, it will record the revenue of $45 every month after the member receives the workout plan.
How to get revenue recognition right
The revenue recognition standard, ASC 606: Revenue from Contracts with Customers, provides a uniform framework within GAAP for recognizing revenue from contracts with customers, wherein businesses are required to adhere to a five-step revenue recognition model.
Updated on Jan. 1, 2018, the standard simplifies the revenue recognition process and brings greater consistency to financial statements across industries.
Five-step revenue recognition model
Step 1: Identify the contract with the customer – Whether written, oral or implied, there must be a contract in place that clearly defines the rights and obligations of both parties. All parties involved must approve of the contract and be committed to fulfilling their obligations.
Step 2: Identify the contractual performance obligations – Make note of the products and/or services promised to the customer (that is, performance obligations).
Step 3: Determine the transaction price – This entails determining the amount of consideration the company expects to be entitled to, in exchange for transferring promised goods or services to the customer. This does not include any amount collected on behalf of third parties, like sales tax.
Step 4: Allocate the transaction price to distinct performance obligations – This involves assigning the transaction price to every performance obligation in the contract based on its relative standalone selling price or expected value as required.
Step 5: Recognize the revenue – The final step is to recognize revenue when or as the performance obligations in the contract are satisfied; that is, when you’ve transferred control of the goods or service to your customer.
Implementing revenue recognition requires scrutiny of each individual contract. And as the business ramps up and gains more contracts, the process of revenue recognition becomes even more complicated and time-consuming.
Opting for outsourced accounting for your growing business can ensure revenue recognition compliance and accurate financial reporting while allowing your team to focus on their core competencies.
Revenue recognition FAQs
I own a small business. Do I still need to comply with revenue recognition requirements?
Small businesses do need to have a good understanding of revenue recognition and its associated principles. Even though many smaller companies are private and therefore not required to follow GAAP in the U.S., they are advised to comply with revenue recognition principles.
As GAAP financial statements are commonly understood by lenders and investors and add credibility to the financial reporting and the company as a whole, having GAAP-compliant revenue recognition practices and financial statements can open up more financing options and sources for growing small businesses.
In short, it’s a good idea to get compliant ahead of time if you plan to expand or seek financing down the road.
How does revenue recognition help my business?
Revenue recognition isn’t just for compliance — it helps businesses recognize revenue consistently. Internally, following the standards for revenue recognition will help your business review and compare its current financials to past records without qualms.
Plus, it will allow easy external comparison so you can quickly gauge your performance relative to competitors. Further, it will help provide your prospective investors with an up-to-date picture of your business’s financial situation.
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