Revenue recognition isn’t just a fundamental accounting principle—it also plays an important role in business valuation and funding. The better you understand how it works, the more likely you are to attract the lenders or investors you need.
In some types of businesses, like retail, for example, recognizing revenue is as simple as making a sale. In others, like subscription-based technology businesses, the process is a little more complicated.
If you’re not sure how revenue recognition applies to your small business, this guide is for you.
What is revenue recognition?
The Revenue recognition principle refers to the way businesses recognize or account for their revenue.
- Businesses using cash accounting recognize revenue when cash is received—regardless of when goods or services are delivered.
- Businesses using accrual accounting recognize revenue when goods or services are delivered—regardless of when cash is received.
Revenue recognition gets a little tricky, however, when businesses deliver subscription-, membership-, or project-based goods or services, or charge a retainer fee.
That’s why in 2014, the Financial Accounting Standards Board (FASB), together with the International Accounting Standards Board (IASB), regulated the recognition of revenue from contracts with customers by issuing the ASC 606 and IFRS 15 revenue standards.
With the effective date impacting annual reporting periods beginning after December 15, 2017, these revenue recognition standards now make it easier to compare financial statements across multiple industries.
3 Key revenue recognition terms you should know
Here are the 3 types of revenue that may impact your business.
- Earned revenue (aka recognized revenue) – When goods or services have been delivered, and cash has been received, earned revenue is recorded as income in your financial accounts.
- Accrued revenue – When goods or services have been delivered, but cash has NOT yet been received, accrued revenue is recorded as a receivable to reflect the money owed to your business.
- Deferred revenue – When cash has been received, but goods or services have NOT yet been delivered, deferred revenue is recorded as a liability to reflect the money owed by your business.
Types of businesses affected by revenue recognition
Certain types of businesses are more affected by international financial reporting standards than others.
Let’s look at a few common examples.
These include businesses that collect annual subscription amounts for services delivered over the course of the year (like SaaS startups and membership-based gyms).
Let’s say your software company runs a marketing software subscription service where clients pay $9000 for an annual subscription—but you provide them with software access every month.
When would you recognize revenue?
Because you recognize revenues only when they’re earned (i.e., when services are delivered), you’d recognize $750 of revenue each month ($9000 ÷ 12).
That means you’d record $9000 as deferred revenue at the start of the subscription period, and recognize $750 of earned revenue monthly after providing your service (note that the amount of deferred revenue would decrease accordingly each time you deliver your service).
These include businesses that receive payment upfront for projects that take place over a period of time (like consulting, contractor, and construction firms).
Let’s say you’re a freelance marketer and your client has paid you $8000 for 3 separate tasks—$3000 for creating a website, $2000 for brand design, and $3000 for creating a marketing strategy.
When would you recognize revenue?
In this case, you’d record $8000 as deferred revenue when the client’s payment is received, and recognize:
- $3000 of earned revenue when you deliver the completed website
- $2000 of earned revenue when you deliver the brand design
- $3000 of earned revenue when you deliver the marketing strategy
These include businesses that charge a fee upfront to guarantee their availability or commitment (like lawyer firms, business consultants, marketing agencies, and other professional services).
Let’s say your business consulting firm charges clients a monthly retainer of $500—based on providing 5 hours of consulting services each month at $100/hour.
When would you recognize revenue?
In this case, you’d record $500 as deferred revenue when payment is received at the start of each month, and recognize a corresponding portion of that payment as earned revenue at the end of each month:
- If you consulted for 4 hours in a given month, you’d recognize $400 as earned revenue and refund or credit the $100 difference
- If you consulted for 6 hours in a given month, you’d recognize $500 as earned revenue and bill your client for the $100 difference
Why is revenue recognition important?
Revenue recognition is important for two reasons: it provides a more accurate representation of your company’s financial health and performance—and it’s something every capital markets lender or investor looks for.
Going back to our software company example, if you recognized your client’s $9000 payment when it was received, your revenue would be overstated in January and understated for the rest of the year (i.e., January revenue = $9000 / February-December revenue = $0).
By applying revenue recognition rules to realize and earn $750 monthly, you generate a more genuine reflection of your company’s financial position.
Recording your revenues and expenses according to recognized standards doesn’t just make your financial statements (including your balance sheet and income statement) more consistent and credible—it makes it easier for funders to understand and compare your business with other companies in the same industry.
How to recognize revenue in 5 steps
Here’s a brief breakdown of how to recognize contract-based revenue in 5 easy steps.
Step 1: Make sure your contract outlines exactly what you and your customer have agreed to with regards to your performance obligations (i.e., the goods or services you’ll deliver) and payment terms.
Step 2: Include the total amount you’ll be charging for your goods or services, including any applicable credits, discounts, refunds, or performance bonuses.
Step 3: To accurately recognize revenue, you’ll need to split out and classify each product or service being provided, along with their delivery dates.
Step 4: For each item in your contract, break out the pricing involved (even if it’s only an estimate) and ensure it matches the total amount.
Step 5: Each time you deliver a product or service in your contract, recognize the appropriate revenue amount in your financial accounts.
Revenue recognition know-how is essential for contract-based organizations like SaaS companies, real estate firms, and fitness studios.
If you need help filling your accounting gaps, find out how Enkel’s bookkeeping experts can keep your back office running smoothly.