Revenue recognition. You’ve heard of it, you know you need to follow it. Maybe your accountant already does it for you! But you aren’t exactly sure what it is, why it is, and how it’s done.
This article will tell you all you need to know. Let’s get started!
What is Revenue Recognition?
Revenue recognition is an accounting method for big contracts and upfront payments, situations where the customer pays in full before actually receiving the whole service. For example, if you sell a SaaS product, you might have a customer pay upfront for an annual contract (lucky you!), though they receive the services of that subscription on a monthly basis.
Basically, you get the money before earning it. Or, in accounting language, before “fulfilling performance obligations.” (We’ll explain that more in a second.)
Revenue recognition dictates that although you received this payment in one chunk, you can earn it only in pieces. You recognize the revenue as you provide the service, as you fulfill the obligations laid out in the contract.
As a result, revenue recognition accounting shapes how you perceive your business’s performance and especially how you report your business’s performance.
According to the Financial Accounting Standards Board (FASB), the purpose of revenue recognition is “to report useful information to users of financial statements about the nature, amount, timing, and uncertainty of revenue from contracts with customers.”
Why does revenue recognition matter for SaaS and subscription businesses?
Revenue is perhaps the most crucial data point for any business. How it’s measured, recorded, and reported is important. Reviewing a company’s performance and prospects.
Revenue recognition is not just a US GAAP standard. It’s expected around the world. The FASB and the International Accounting Standards Board (IASB) teamed together to create one revenue recognition standard, which has been in effect since January 2018: IFRS 15 Revenue from Contracts with Customers.
Any business that operates through customer contracts should use revenue recognition. Businesses across all kinds of industries use it.
It’s especially important for businesses with recurring revenue. SaaS and subscription businesses, most of whom charge on a monthly basis, must be sure to recognize payments as revenue only after the monthly service period has ended.
A related practice is accrual-based accounting. To learn more, read on about how accrual-based accounting works and why it's necessary for SaaS and subscription businesses.
Best practices for implementing revenue recognition
Identify each good or service, then whether it represents a performance obligation, and then only recognize revenue as each performance obligation is fulfilled.
Divide payment into a transaction price for the underlying service, e.g. monthly cost. Except when you have a discount or other variable (rebate, bonus, right of return). There’s a specific model to use if any of these variables apply to your customer’s payment. You also have to consider the likelihood that these variables will be reversed. Will you retract a discount, will a deal be reversed?
5 steps for revenue recognition
1. Identify the contract with a customer
There are three requirements that need to met in order to consider a contract “identified.”
Both parties approve the contract and have committed to it.
Both parties’ rights and obligations are clearly stated in the contract.
Payment terms are clearly stated and understood in the contract.
2. Identify the performance obligations in the contract
A performance obligation is a distinct good or service that you’re providing to the customer. To be considered “distinct,” two requirements need to be met.
The promise to transfer good or service must be defined separately and easily identifiable in the contract.
The good or service itself can be consumed or used by customer.
3. Determine the transaction price
Usually this is straightforward. Transaction price is the amount you expect to get paid, as listed in the contract. But if, for some reason, it isn’t straightforward for your business, you should definitely check with an accountant to make sure you’re using the right method to determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract
What does each performance obligation cost, on its own? This can vary. A set-up fee is a one-time fixed cost. Usually for subscriptions, allocating the transaction price amounts to the average price, in increments over the contract time period. Treat each performance obligation, or service period, as a stand-alone sale. For example, for a subscription business, it would be the cost of your service for March, for April, for May, etc.
5. Recognize revenue recognition when the performance obligation is fulfilled
When your customer has received the good, or can access the service for the slotted amount of time, and use it at their own discretion — then the performance obligation is considered fulfilled! And you have earned the revenue. Yay! As mentioned above, the performance obligations could be satisfied at a single point in time or over a period of time (subscription style).
Be sure to include disclosure requirements!
Disclosure requirements are specific explanations that you must include on your financial statements. These are designed to help whoever’s reading your financial statement to make sense of everything. These disclosures add clarity, transparency, and consistency to all financial statements — and they can be a lot of work. Because of this extra workload, private businesses are exempt from some of the requirements.
Disclose the portion of the transaction price that has yet to be recognized, i.e. the revenue allocated to “remaining performance obligations.” Then you should estimate and explain when you expect to recognize that waiting revenue.
Explain the methods, inputs, and assumptions you used to estimate the amount of variables and potential for reversed revenue.
If you’ve made any changes to the contract during that reporting period, explain them!
Plus some more complicated, niche-case disclosures! You can find more information in the Resources section below. :)
What will help?
Well, other than getting fully certified as an accountant yourself, there are some ways you can make revenue recognition easier on your business.
Using a software tool that automatically tracks your revenue is a great start. With Quaderno, you can view intelligent financial reports with real-time data any time you want. You can freely export these reports as a CSV file, to Xero, or share them directly with your accountant.
In fact, your accountant can have direct access to your Quaderno account — removing you as the data middleman. With Quaderno bookkeeping and tax filing will be a breeze for them, and you don’t have to lift a finger. Their time is used smarter, your money goes farther.
Sign up for a free 7-day trial and let us take care of tax compliance and revenue reporting for you.
* At Quaderno we love providing helpful information and best practices about taxes, but we are not certified tax advisors. For further help, or if you are ever in doubt, please consult a professional tax advisor or accountant.