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6 Revenue Recognition Methods You Need

This blog digs deep into the importance of accurate revenue recognition and explores six common methods: sales-basis, percentage-of-completion, completed contract, installment, cost-recovery, and accrual. Learn how to evaluate industry norms, contractual obligations, and revenue stream timing to select the best revenue recognition method for your business, ensuring compliance with ASC 606 standards.

Sakshi Jha

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Say, you’re running a SaaS business selling services to thousands of customers. Each month, revenue pours in from these subscriptions, but when can you count that money as “earned”?

Accurately recording revenue is about more than just when cash flows in.

It's about understanding the concept of revenue recognition, an important part of financial statements.

Previously, revenue recognition practices were inconsistent, leading to potential manipulation and confusion. However, introducing the ASC 606 standard by the Financial Accounting Standards Board (FASB) has brought much-needed clarity.

And, this blog post is your guide to the world of revenue recognition.

We'll explore the different methods available, and how to choose one for yourself so your financial statements reflect a true and transparent picture of your company's success.

What is Revenue Recognition?

Revenue recognition is the process of recording and reporting revenue earned from the sale of goods or services. It is an accounting principle that determines when revenue should be recognized (recorded) in the financial statements of a company. The timing of revenue recognition is vital because it directly impacts financial performance metrics, profitability analysis, and the financial health of the organization.

The process of revenue recognition involves several key steps —-

1. Identifying Contracts:

Recognizing revenue begins with identifying contracts with customers. These contracts outline the terms for delivery of goods or services and specify the consideration (payment) the company expects to receive.‍

2. Fulfilling Performance Obligations:

After contract identification, the company determines the performance obligations it must fulfill. A performance obligation is a promise to transfer a distinct product or service to the customer.

3. Determining Transaction Price:

The transaction price is the amount of entitled consideration (payment) to the company in exchange for transferring goods or services to the customer. It includes fixed amounts, variable consideration, discounts, and any other adjustments.

4. Allocating Transaction Price:

If a contract includes multiple performance obligations, the transaction price gets allocated to each obligation based on its standalone selling price. This ensures that the revenue recognized is appropriate for each obligation.

5. Recognizing Revenue:

Revenue is recognized when (or as) the company satisfies each performance obligation by transferring control of the promised goods or services to the customer. This might occur at a point in time (e.g., upon delivery) or over time (e.g., as services are provided).

Why is Revenue Recognition Important?

But why should you bother with revenue recognition? Let’s tell you what happens if you aren't bothered with it.

Improper revenue recognition can lead to inflated revenue figures, creating a misleading picture of your company's health. This can damage trust with stakeholders and potentially lead to legal or regulatory repercussions.

For instance, Byju’s, a leading edtech firm, experienced a substantial widening of losses due to changes in accounting standards, delaying revenue recognition by up to 40% in FY21. This loss could’ve been stopped if the company had adopted the appropriate revenue recognition method.

Here's why proper revenue recognition is critical for any business —-

1. Accurate Financial Reporting:

Revenue recognition ensures your financial statements accurately reflect your company's true financial performance. This transparency allows stakeholders to make informed decisions based on reliable information.

2. Investor Confidence:

Investors rely on revenue figures to assess a company's health and growth potential. Consistent and credible financial statements, built on proper revenue recognition, build investor confidence in your business.

3. Transparency for Creditors:

Accurate revenue recognition ensures creditors have a clear picture of your company's ability to repay debts.‍

4. Compliance with Standards:

Revenue recognition follows established accounting principles (GAAP or IFRS) depending on your location. Following these guidelines ensures your financial statements comply with regulations and avoid potential legal issues.

5. Internal Decision-Making:

Accurate revenue figures provide valuable insights for internal decision-making. You can assess profitability, cash flow, and resource allocation more effectively with reliable data.

What is the revenue recognition method?

The revenue recognition method refers to the process of deciding the different conditions under which a business recognizes and records revenue. It involves a set of steps to decide how and when the inflow of revenue is recorded in the company’s financial statements.

6 Common Revenue Recognition Methods

But how exactly do you recognize income as revenue?

Here, are the 6 common revenue recognition methods outlined in the ASC 606 framework —-

1. Sales-Basis Method:

Revenue is recognized at the point of sale after delivery of goods or services to the customer. Think of a grocery store - when you buy a box of cereal, the sale gets recorded immediately, even if you pay with a credit card. This method is straightforward and is commonly used in retail environments where goods are sold directly to customers.

2. Percentage-of-Completion Method:

Businesses that undertake long-term projects, such as construction companies, often use the percentage-of-completion method. Recognize revenue based on the percentage of the project completed.

For example, if a construction project has a total contract value of $1,000,000 and after completing 50% of the project's milestones, revenue of $500,000 would be recognized.

3. Completed-Contract Method:

This method is best suited for short-term projects or situations where progress is difficult to measure. Unlike the percentage of completion method, the completed contract method recognizes revenue only when the entire contract is fulfilled and all obligations are met.

4. Installment Method:

The installment method is ideal for businesses selling high-ticket items with extended payment plans. Recognize revenue proportionally as you receive payments from the customer.

Think of a car dealership where a customer finances a car. The dealership would recognize revenue as each monthly payment received. It's useful when there's uncertainty about the customer's ability to pay the full amount upfront.

5. Cost-Recovery Method:

Revenue recognition happens only after all the recovery of costs associated with delivering the goods or services. This is often used when there's a high risk of delayed or uncertain payments.

For example, a consulting firm might use this method if a client has a history of late payments.

6. Accrual Method:

The accrual method recognizes revenue when earned, regardless of when payment arrives. It matches revenue with the expenses incurred to generate that revenue. It's often used for prepayments, where the customer pays upfront for goods delivered later.

For example, a SaaS company recognizes monthly revenue as customers use their software, even for annual payments.

Each of these methods has its advantages and you must choose one based on the circumstances of your business and the nature of your contracts.

How to Decide on a Revenue Recognition Method?

Firstly, start with understanding industry norms and your specific business model. Industries often have preferred methods based on regulatory requirements or customary practices; for example, retail typically employs the sales-basis method, recognizing revenue at the point of sale.

Secondly, evaluate your contractual obligations when transferring goods or services to customers. This will help guide the method selection to fulfill performance obligations over time.

Thirdly, consider the timing and predictability of your revenue streams. Methods such as the installment method may be suitable if your business receives payments over an extended period, allowing revenue recognition to match cash inflows.

Next, assess how each method impacts your financial statements. For instance, methods like the completed contract method can lead to revenue fluctuations, influencing profitability metrics and management decisions.

Furthermore, ensure compliance with ASC 606 guidelines, which has a structured framework for revenue recognition from contracts with customers.

Why Zenskar?

There are so many rules and criteria you need to follow when deciding upon a revenue recognition method. Plus, consulting accounting and legal professionals can add more work to their table.

It matters like these, which makes tools like Zenskar an advantage.

Zenskar offers a robust platform designed to streamline revenue recognition processes, ensuring adherence to ASC 606 guidelines while providing flexibility to manage various revenue models.

With Zenskar, businesses can automate revenue calculations, track performance obligations, and generate accurate financial reports, enhancing transparency and reliability in financial reporting.

The software's integration capabilities and user-friendly interface make it a practical choice for businesses looking to optimize their revenue recognition practices.

Frequently Asked Questions

1. What are the types of revenue recognition methods?

Revenue recognition methods include:

Sales-basis method: Recognizes revenue when goods or services are delivered.
Percentage of completion method: Recognizes revenue based on project milestones or costs incurred.
Completed contract method: Recognizes revenue only upon complete contract fulfillment.
Cost recovery method: Recognizes revenue after recovering all contract costs.
Installment method: Recognize revenue as payments come in over time.

2. What is the ASC 606 revenue recognition method?

ASC 606 is a comprehensive standard by the Financial Accounting Standards Board (FASB) that provides guidelines for revenue recognition. It outlines a five-step model: