Revenue Recognition: Definition & Overview
Handling your finances as a small business owner can be tricky. It’s difficult to understand exactly what is required of you and how to record and recognize your revenue. Luckily, GAAP has a set of detailed rules and guidelines on how business owners should conduct their business. A core principle of GAAP is revenue recognition.
But what exactly is revenue recognition and why is it important? We’ll take a detailed look at the generally accepted accounting principle and how it can help your business.
Table of Contents
KEY TAKEAWAYS
- Revenue recognition stipulates how and when revenue is to be recognized.
- It is a generally accepted accounting principle (GAAP).
- There is a succinct template skeleton for recognizing revenue from sales with customers. It is provided by the revenue recognition standard, ASC 606 (Accounting Standards Codification).
What Is Revenue Recognition?
Revenue is the cash or accounts receivable that a business obtains when it delivers goods or services to its clients. Revenue recognition is an accounting principle that determines when and how much income is reported in the income statement. It also plays an important role in determining how to account for revenue.
Revenue recognition is a part of the generally accepted accounting principles (GAAP). Companies recognize revenue when goods or services are transferred to customers for the amount the business expects to be entitled to receive. You might find yourself receiving the cash earlier or later—depending on various factors. This accounting principle provides guidance to businesses about how to account for income that will be later included in their financial statements.
The Importance of Revenue Recognition
Revenue recognition is crucial for a wide range of businesses. This is especially true for:
- Public companies
- Large businesses with more than $25m USD in annual revenue
- Startup businesses that need to follow accrual accounting for investments
- Service-based and subscription businesses, where customers pay upfront before receiving the services or goods
It’s important to correctly recognize and account for a business’s revenue. When income is recognized properly, you can get the most accurate insights into your company’s profitability and financial health.
Revenue recognition is complex, especially as a business scales and grows. This is because revenue payment volumes and product lines increase making it more difficult to track and recognize.
It can be especially complicated for subscription businesses and independent contractors. This is because they may need to manage a number of things, such as refunds, disputes, and other complex situations. These items can complicate the process of accurately recognizing and deferring revenue, which in turn, makes it harder to be compliant.
It’s also important to adhere to GAAP so that any financial statement your business provides is consistent and comparable with similar information supplied by other companies.
The Requirements for Revenue Recognition
Any public company that is based in the United States follows the revenue recognition standards set out by the GAAP. Private companies are not strictly required by law to comply with GAAP in the US; however, they may need to comply for other reasons.
If a business wants to get a loan from a bank or a cash injection from an investor, they will often require or prefer the company to first be GAAP compliant. So for a company to receive any financing, they must have GAAP compliant financial reporting.
The International Financial Reporting Standards (IFRS) also has a similar approach. Many regions require domestic public companies to be compliant, but many private companies will also be required to have compliant financial statements as well.
Revenue Recognition: ASC 606
The Accounting Standards Codification (ASC) 606 was published in May 2014. It was issued by the Financial Accounting Standards Board, or FASB and the International Accounting Standards Board, or IASB.
ASC 606 provides a framework for recognizing revenue from contracts with customers. Both public and private companies should comply with the ASC 606 principles.
Whereas the old guidance was industry-specific, the updated standard is industry-neutral. This makes the whole process more transparent. It allows for the improvement of the comparability of financial statements. It also allows for standardized revenue recognition practices across multiple industries.
The 5 Steps of ASC 606
ASC 606 identifies 5 steps needed to comply with the updated revenue recognition principle. The steps are as follows:
- Identify the contract with the customer
To complete this step, the parties must approve the contract. They must also be committed to fulfilling their obligations. The contract will outline each party’s rights as well as the payment terms.
- Identify the contractual performance obligations.
During this step, each distinct contractual obligation must be identified. This is a promise in a contract to fulfill a good or service to the customer. Some contracts may involve more than a single performance obligation, but they must be distinct from each other.
- Figure out the amount of price/consideration for the transaction.
This is where the amount of consideration the entity expects to be entitled to in exchange for the goods or services is determined. This doesn’t include amounts collected on behalf of third parties such as sales tax. Most contracts will involve a specific, fixed amount.
- Allocate the correct amount of price/consideration to the contractual obligations.
Some contracts may have more than one performance obligation. If this is the case, a company will need to allocate the transaction price to each obligation. This would be based on its relative standalone selling price.
- Recognize revenue when the performing party completes the performance obligation.
The final step is to recognize the revenue over time. This happens when or as the performance obligations are satisfied. This is according to the predetermined contract. During this step, revenue is recognized either:
- At the point where the buyer takes possession of the goods
- At the point where the service is provided to the buyer
Summary
As a small business owner, accurate revenue recognition is vital in helping you keep in line with GAAP. Being able to properly recognize revenue as well as strategically look at revenue recognition policies is key. This is because it allows you to keep track of your business financial performance and ensure that you stay compliant.
FAQs on Revenue Recognition
Revenue is the money (cash or accounts receivable) that a business generates from normal business operations. It is calculated as the average sales price multiplied by the number of units sold or the amount received for services the company provided.
The revenue recognition principle is a feature of accrual accounting. It requires that you recognize revenue on the income statement when it was earned and realized, and not necessarily when the cash was received.
When recording the entry into the accrual journal, it involves a debit to the accounts receivable account. This is then followed up by a credit to the sales revenue account. If cash was used for the sale, then the business’s cash account would instead be the one that is debited.
Having GAAP-compliant revenue recognition practices is key. Revenue is required to be recognized according to the accounting principles provided by the GAAP. This is a feature of accrual accounting. This means that revenue is not always recognized when a business receives cash. Instead, it is reported in the income statement at the time it is realized and earned.
Share: