Guide to Revenue Recognition

Omar Visram
Guide to Revenue Recognition
Table of Contents

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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, recognizing revenue is as simple as making a sale. Basically, revenue is recognized at the point of sale because it involves an immediate cash transaction. The process is a little more complicated in others, like subscription-based technology businesses. 

If you’re unsure 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. It is foundational to accrual accounting and part of the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) that dictate how revenue is recognized on a business's financial statements.

In the revenue recognition principle, revenue should be recognized in the accounting period in which it is earned, regardless of when the payment is received. It matches revenues to the periods in which the goods or services are delivered, aligning revenue with the expenses incurred to generate that 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 can be tricky 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) and the International Accounting Standards Board (IASB) issued the ASC 606 and IFRS 15 revenue standards to regulate the recognition of revenue from contracts with customers. 

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.

  1. Earned revenue (aka recognized revenue): When goods or services are delivered and cash is received, earned revenue is recorded as income in your financial accounts. 
  2. 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.
  3. 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 

International financial reporting standards affect certain types of businesses more than others. Let’s look at a few common examples.

Subscription-based businesses

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 revenues are recognized 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).

Project-based businesses

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

Retainer-based businesses

These include businesses that charge a fee upfront to guarantee their availability or commitment (like law firms, business consultants, marketing agencies, and other professional services). Revenue is recognized as the services are performed. Retainer fees paid in advance are initially recorded as deferred revenue (a liability) and progressively recognized as revenue as the services outlined in the retainer agreement are provided.

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 regard 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: Break out the pricing involved for each item in your contract (even if it’s only an estimate) and ensure it matches the total amount.

Step 5: Recognize the appropriate revenue amount in your financial accounts each time you deliver a product or service in your contract.

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.

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