- What is revenue recognition?
- Does my company need revenue recognition?
- Examples of revenue recognition
- What to do with the revenue that hasn't been earned yet?
- Revenue recognition 606 - The new rules of revenue recognition
- How does revenue recognition work under ASC 606?
- Why was a new standard on revenue recognition issued by FASB?
What is revenue recognition?
Revenue recognition in the most simple terms means if an organization has earned revenue.If a business uses the cash-basis of accounting, then it is said to have earned revenue when cash is received in their bank account.
For businesses that use accrual-basis accounting, the revenue recognition principle is different. Under the accrual basis, the revenue is recognized only when it has been earned.
To be able to know when revenue recognition has to be done is one of the reasons why we have Generally Accepted Accounting Principles (GAAP). GAAP provides detailed rules & regulations for when and how to recognize revenue, and how to report it on an organization’s income statements.
You might have heard of the International Financial Reporting Standards (IFRS). IFRS is like the metric version of GAAP; while the USA uses GAAP, the rest of the world uses IFRS. IFRS is administered by the International Accounting Standards Board (IASB).But what’s the difference between them? GAAP is a set of rules an organization needs to follow, while IFRS is a set of broad guidelines. The most recent version of this standard is IFRS 15.
Entities outside an organization often require the company’s financial statements to adhere to GAAP or IFRS. The main reason for this is to be able to recognize revenue in a familiar, standardized way.
Does my company need revenue recognition?
Revenue recognition is important for any company that receives money from its customers, as that is considered as earnings.Some examples of businesses that need revenue recognition are:
- Subscription-based businesses (like software companies, membership sites, publications, etc.)
- Contractors who receive advance payments for projects
- Professionals who collect payments for a retainer
Examples of revenue recognition
Let’s say that you have a bookstore in New York, and it also runs a book club. The customers pay you $450 in advance for an annual subscription, and every month your bookstore sends them three books from the best-sellers list to you. When is the revenue recognized?
You will most probably recognize only $50 of the revenue every month. Just because you received a payment of $450 from one of your customers does not imply that you have earned the complete $450. If for any reason, you have to cancel a member’s subscription before their contract ends, you would have to owe the customer money.
What to do with the revenue that hasn't been earned yet?
Revenue that has been received but not recognized is known as deferred revenue or unearned revenue. Accountants classify deferred revenue as a liability, as it is money you owe your customers.
For example, if the bookstore from the above example collects $500 at the beginning of the year, the bookstore will initially have to consider all of the $500 as deferred revenue.
If an organization collects revenue that hasn't been recognized yet, it is categorized in the deferred revenue column as a liability. At the end of each month, the amount that has not been recognized is moved over from liability to income.
Deferred revenue is a reason why it’s so important to execute revenue recognition correctly. Lenders and investors always want to make sure that all of your company’s liabilities are spelled out clearly in the financial records.
Revenue recognition 606 - The new rules of revenue recognition
Back in 2014, the organization that is in charge of GAAP, the Financial Accounting Standards Board (FASB), announced that they would be establishing a new revenue recognition standard.
The new standard was called ASC 606. It was meant to make a comparability between financial statements better. What this means is that investors can compare income statements and balance sheets from different companies, and measure performance relative to each other.
The ASC 606 meant that there would be major changes in the way an organization recognized revenue, especially if it operates on a subscription model. It started going into effect for publicly-traded companies back in 2017 and went into effect for other organizations in January of 2019.
How does revenue recognition work under ASC 606?
There are five steps that all organizations have to go through to recognize revenue:
1. Getting clear on the contract with your customer
Organizations have to make sure that the agreement signed with your customer mentions clearly what goods or services are being delivered, and what the payment terms would be for the same.
2. Identifying performance obligations in the contract
If the contract contains more than one good or service, they are to be identified and separated.
3. Determining the complete transaction price
Companies have to make sure that the agreement that is signed with the customer mentions the amount that is being charged from them for the goods and services that are being delivered.
4. Matching transaction prices to the performance obligations of the contract
Organizations have to break down the price of each good that is being delivered.
5. Recognizing revenue as each good or service is delivered
Companies have to make sure that they recognize revenue only after the goods or services have been delivered after being separated and priced.
Why was a new standard on revenue recognition issued by FASB?
Revenue is one of the most important measures used by investors while assessing an organization’s performance. However, previous revenue recognition guidance structures were different in Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
On 28th May 2014, the FASB and the International Accounting Standards Board (IASB) issued a converged guidance system to recognize revenue in contracts with customers. The new guidance was a major achievement in the Boards’ joint efforts to improve the efficiency of financial reporting.
The objective of the new guidance was to establish principles to report data that would be helpful to the users of financial statements about the nature, amount, and timing of revenue from contracts with customers.
We hope this article cleared your doubts about revenue recognition. Keep reading our other articles to improve your understanding of financial accounts.