A Short Guide on Revenue Recognition
Businesses operate with varying focus areas, such as product outreach, streamlining operational costs or strengthening financial reporting mechanisms. However, their success broadly depends on revenue recognition, i.e., their ability to accurately manage and account for their profits and losses, which requires recognizing and outlining revenue to calculate their earnings. The revenue’s size makes it arguably the most critical item in the organizational income statement. Irrespective of the size or business priorities, growing revenue is the foremost consideration for most organizations. It helps decode profitability besides assessing the effectiveness of sales and marketing channels and indicates the state of liquidity – which is necessary for growth and expansion.
Thus, organizations use different accounting principles for distinct business needs. Revenue recognition is one of the accounting principles that organizations use to understand the state of their finances. The way in which organizations decide whether or not a transaction qualifies as revenue is called revenue recognition.
The principles and rules for recognizing revenue were enshrined in a new global revenue recognition standard effective in 2018 – the ASC 606 accounting standard in US GAAP and IFRS 15 (International Financial Reporting Standard). For the unversed, the ASC 606 accounting standard replaced the previously used ASC 605 to enhance the USA’s GAAP revenue recognition standards compliance with the IFRS. Plus, the new standard also helped standardize revenue recognition across industries. This new standard aims to recognize revenue for transferring goods and services promised to customers in the amount reflecting the expected consideration in exchange for the said services or goods.
What Is Revenue Recognition?
Revenue recognition is a Generally Accepted Accounting Principle (GAAP) that organizations employ to determine the conditions in which they can recognize the revenue and assess the means of accounting for it. This means that organizations can recognize the revenues when customers consider their products or services delivered. However, organizations cannot recognize the revenue without getting paid for the offered goods or services. For example, if a buyer subscribes to Netflix for an annual sum of US$ 240, then Netflix will account for US$ 20 of revenue each month.
Organizations must meet the IFRS’s stipulated criteria to recognize revenue listed below:
- The seller transfers the risks and rewards of the ownership of the product or the service to the buyer.
- The seller relinquishes control over the sold goods or services.
- When the seller is guaranteed payment for the goods or services rendered.
- When the seller can measure the cost and the amount of revenue.
Why Is Revenue Recognition Important?
Revenue recognition is critical for several reasons. Let us learn about them.
The new ASC 606 and IFRS 15 standards mandate that organizations now recognize revenue when they offer goods or services to their clients in the amount equal to what they have delivered at that point. However, this can be a tricky mandate for businesses offering subscription-based services as they do not offer tangible services.
2. Financial Planning
The organizational ability to recognize revenue directly affects its sales commission and compensation plans, market outlook, expansion and growth strategy and even product strategy. Revenue recognition provides the management with a precise financial position of the organization, allowing them to manage their operations better and make necessary investments for growth.
3. Investment Opportunities
Every organization seeks growth for which they require a steady inflow of money. Some organizations prefer investors and attract them by hard-selling their growth story. However, every astute investor likes access to revenue recognition numbers. This accurate revenue insight is critical for them to make informed investment decisions.
Five Steps to Revenue Recognition
Organizations must follow a five-step process to create a revenue recognition contract. This contract between the seller and the buyer outlines the obligations of both parties.
1. Identify the Customer Contract
Organizations usually prefer written and vetted contracts. However, an organization can choose to ink the contract based on its prevalent practice, such as even a verbal or informal contract. These practices are rare, though. The contract details the terms of payment and rights of the services or goods that the seller will hand over to the client for a mutually agreed upon sum of money.
2. Determine the Performance Obligations
Once an organization gets into a formal agreement, it determines the customer’s obligations. These obligations are promises that the seller makes to the customer in return for the payment and can consist of a good or service or multiple goods or services. Organizations must individually identify each obligation.
3. Fix the Cost of the Transaction
The transaction cost may be fixed or may vary, depending on the agreement between the two parties. The contract may include a fixed consideration, a variable consideration, or a mix of the two. If an organization has inked a contract with the variable complement, it must zero in on the amount expected. Organizations consider their variables based on future events, which can be cash or non-cash.
4. Assign the Transaction Price to the Contract’s Performance Obligations
The organization must assign a contract consideration for every performance obligation mentioned in the contract. The seller should determine the transaction price based on the observable price of each good or service. It can also use an estimated selling price if it cannot ascertain the sum of the good or the service.
5. Recognize Revenue After the Performance Obligation Is Fulfilled
The organization can recognize revenue individually for performance obligations. Notably, any obligation is satisfied only when the buyer controls the good or the service rendered by the seller. Also, this control of goods or services may occur at once or in installments, depending on what is being sold and purchased. As a result, the revenue is recognized at once or in installments.
How Polaris PSA Can Help
Polaris PSA allows professional services firms to manage service delivery, billing and revenue recognition for services. It offers a unified platform-based model and advanced configurability to map out revenues while ensuring all business process needs are met.
Replicon’s time-tracking solutions with built-in revenue recognition component enable professional services organizations to:
- Get a comprehensive picture of their current and future projects, resource utilization and cash flow.
- Implement Financial Management, Service Delivery Management, Project Accounting, and Current and Future Utilization, which are basic requirements of any PSO.
- Easily configure how and when to recognize revenue from their operations with a unified system and platform approach.
Revenue recognition can be confusing, particularly for companies dealing with long-term contracts and offering a mix of products and services. Replicon’s revenue recognition platform is the ideal enabler for businesses that empowers them to focus on the big picture with confidence.