Figuring this all out is called “revenue recognition,” and it’s a big challenge for entrepreneurs. Not just because it’s complicated, but also because if your business has investors or creditors, there are complex rules around it.
In this guide, we’ll cover what revenue recognition is and how to make sure you’re doing it right.
What is revenue recognition?
You’re likely already aware of revenue—also known as the total income generated by your business before any expenses—but you might be less familiar with the accounting definition of recognition.
In accounting, “recognizing” an event or transaction means formally recording it in the business’s financial statements.
Revenue recognition means recording when your business has actually earned its revenue—and that’s where it starts to get complicated.
If your business uses the cash basis of accounting, revenue recognition is easy: you earn your revenue when the cash hits your cash register or bank account.
It’s different for businesses that use the accrual basis of accounting. The revenue recognition principle under accrual accounting means that you recognize revenue only when it’s been earned—which may be days, weeks, or months from when it’s actually paid.
Where do these rules come from?
Knowing when to recognize revenue is one of the reasons why we have Generally Accepted Accounting Principles. GAAP is a set of generally accepted accounting principles, standards, and procedures that public companies in the U.S. must follow when they compile their financial statements. There are detailed rules under GAAP that regulate when and how to recognize revenue and report it on your income statements.
As well as the U.S. GAAP, you may have heard of International Financial Reporting Standards (IFRS). Think of this revenue recognition system as the metric version of GAAP—while the USA uses GAAP, most of the rest of the world uses IFRS. It’s administered by the International Accounting Standards Board (IASB).
So, what’s the difference? In a nutshell, GAAP is a set of rules you need to follow, while IFRS is a set of principles or broader guidelines. The most recent version of this standard is called IFRS 15.
Unless you’re operating outside the United States, you don’t need to worry about the IFRS revenue recognition standard. However, if you expand beyond American borders, you should talk to a certified accountant about adhering to IFRS.
People outside your company, like investors, will often require that your financial statements adhere to GAAP or IFRS. This is because they want you to recognize revenue in a way that is familiar, standardized, and not misleading.
Do I need to worry about revenue recognition?
Revenue recognition matters to any company that collects money from its customers before it actually earns that money.
Examples of businesses that need to think about revenue recognition include:
- Subscription businesses (like publications, software companies, membership sites, etc.)
- Contractors who get paid for projects up front
- Professionals who collect a retainer
While private companies technically don’t need to follow GAAP rules, it’s a good idea to get compliant ahead of time if you plan to expand or seek financing down the road.
Examples of revenue recognition in action
For a subscription service
Let’s imagine that your Los Angeles-based wine store, the Vine Cellar, runs a monthly wine club. Your customers pay you $600 up front for an annual subscription, and every month you send them three bottles of ground-breaking organic wine to their doorstep. When do you recognize the revenue?
You would likely recognize only $50 of the revenue each month. Just because one of your customers paid you $600 doesn’t mean you’ve earned the whole $600. If, for some reason, you had to cancel someone’s subscription before the end of their contract, for example, you would owe that customer money.
For a contractor
Let’s say that you run a small finance podcast—The Bean Counter. You’ve built up a sizable listenership over the years, and one day, a big accounting firm approaches you and offers you $9,000 for three months of ads on your podcast. When do you recognize the revenue?
As in the previous example, you’d probably split the $9,000 fee over three reporting periods, and recognize revenue only after each month’s ads had run. So, in this case, you would recognize $3,000 in revenue every month.
What do I do with the revenue I haven’t earned yet?
Revenue that you’ve collected but not recognized is called deferred revenue (or “unearned revenue”). Even though it has the word “revenue” in the name, accountants classify deferred revenue as a liability because it is technically money you owe your customers.
For example, when the wine store from the example above collects $600 at the beginning of the year from a customer, the store would initially have to record all $600 as deferred revenue.
So, if you do collect revenue you haven’t recognized yet, categorize the deferred revenue as a liability on your books. Then each month, move the amount you’ve recognized over from liability to income (from “deferred revenue” to plain old “revenue”).
Deferred revenue is one reason why it’s so important to do revenue recognition right. Investors and lenders want to make sure that all of your liabilities are spelled out clearly in your financial records and that you’re not recording debts as revenues!
How Bench can help
If you’re a Bench customer, your bookkeeper will take care of recording your deferred revenue properly. So, for example, if you collect an annual subscription fee in January, your books won’t show all that revenue at once; you’ll see it on your financial statements one month at a time, as you earn it. Learn more about bookkeeping with Bench.
The rules of revenue recognition have changed
In 2014, the organization in charge of GAAP, the Financial Accounting Standards Board (FASB), announced they were establishing a new revenue recognition standard.
They called the new standard ASC 606. It’s meant to improve comparability between financial statements of companies that issue GAAP financial statements. In theory, this new guidance allows investors to line up income statements and balance sheets from different businesses and see how they perform relative to one another.
It also makes changes to the disclosure requirements for companies—what type of information they provide investors.
The ASC 606 could mean big changes for the way your business recognizes revenue, especially if you operate on a subscription model. It went into effect for publicly-traded companies in 2017 and went into effect for everyone else in January of 2019.
How revenue recognition works under ASC 606
It’s complicated, but it all boils down to a five-step process that all companies must follow in order to recognize revenue properly:
1. Get clear on your contract with the customer
Make sure that the agreement you sign with your customer spells out clearly what goods or services you’re delivering and what the payment terms are for those goods or services.
2. Separate performance obligations in the contract
If your contract contains more than one good or service, identify and separate them.
For example, if your subscription wine-delivery service also offers online wine-tasting lessons and customer support, make sure not to miss those when recognizing revenue. Remember things like discounts, refunds, credits, bonuses, incentives, etc.
3. Determine the total transaction price
Make sure the agreement you sign with your customer spells out clearly how much you’re charging them for all of the goods and services you’re delivering.
4. Match the transaction price to the performance obligations in the contract
Break down the price of each individual good or service you’re delivering. If you don’t have an exact price for each good or service, estimate it.
5. Recognize revenue as you deliver each separate good or service
Make sure to recognize revenue only after delivering the promised goods or services you separated and priced out in steps 1-4.
Do these changes affect my business?
The software as a service industry (SaaS) was drastically affected by ASC 606, mainly because of how inconsistent and unclear SaaS accounting used to be before the changes.
The SaaS business model often bundle lots of different services into one plan, and when exactly the services have been delivered to the customer can sometimes be unclear. ChartMogul has an excellent breakdown of how ASC 606 affects SaaS businesses.
But SaaS companies aren’t the only businesses affected by ASC 606.
If your business collects payments from customers upfront and your investors or lenders want your financial records to be in line with GAAP, it pays to read up on ASC 606.
What should I do now?
Figure out how important GAAP is to your business
If you run a very small business with no lenders or investors, you might not have to worry about any of this.
But if you’re a startup looking for investment, a mom-and-pop looking for a bank loan, or looking to sell your business, the way you record revenue needs to be in line with GAAP and ASC 606.
Get clear on the new rules
Read over steps 1-5 of ASC 606 above and make sure you understand how they affect the way you recognize revenue.
Talk to an expert
If you’re not sure how ASC 606 affects your business and can’t make heads or tails of steps 1-5 above, talk to a CPA, preferably one with expertise in your industry who has experience helping similar companies with ASC 606.