What is revenue recognition and why it’s important

What is revenue recognition?

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The money flows in, customers sign contracts, and your business is growing. You’re ready to add your incoming revenue to your books. Or are you? 

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Any accountant will advise you that revenue recognition is not as straightforward as it seems. This accounting principle states that a business can only recognize revenue after it has been earned based on various factors and a set of critical events that must occur between the company and the customer. For example, when the customer physically receives the product or service — not at the time of the initial payment. 

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Below we will cover these specific conditions, provide specific guidance on how to recognize revenue transactions and why it's crucial for startups and small businesses to follow all revenue recognition principles. 

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Why is revenue recognition important?

Most commonly known in accrual-basis accounting as the revenue recognition principle, this key component of bookkeeping is closely regulated by several financial institutions, including the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), and the International Financial Reporting Standards (IFRS). 

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Alternatively, those following cash-basis accounting are not obliged to follow the revenue recognition principle. These businesses may recognize revenue immediately at the time cash is received. 

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Since revenue is one of the most important financial factors that investors and lenders look at when considering involvement with your company, it is imperative that you follow all official guidelines closely. This shows more credibility for your company and integrity for you as a startup leader. 

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Specific criteria for revenue recognition

There are many conditions for revenue recognition depending on your location, business model, investors, and public vs. private entity status. 

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For example, public companies operating within the U.S. must follow GAAP standards.  Private companies are not required to adhere to GAAP or IFRS guidelines. However, if you are looking for financing or expansion opportunities, investors will look to see if you are following these guidelines well before becoming a public company as an outlook or foreshadowing of your ease of compliance with more strict financial reporting requirements. 

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Overall, according to IFRS criteria, companies must meet the following conditions to recognize revenue:

• The seller transfers risk and rewards to the buyer.

• The seller no longer has no control over goods sold.

• Payment collection from goods or services is reasonably assured.

• Amount AND cost of revenue can be reasonably measured.

Steps in the revenue recognition process

In May 2014, the FASB issued ASC 606. This new revenue recognition standard outlines five steps for companies to determine when they can consider revenue earned and update their financial statements.

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Companies must pay close attention to these steps (outlined in-depth here), but let’s briefly take a more straightforward and closer look:

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1. Identify The Contract With Customer — All parties involved must first agree upon the contract terms and commit to the obligations within. A contract must outline in detail each party’s rights and payment terms.

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2. Identify The Performance Obligations Within A Contract — A performance obligation is a promise to transfer a “distinct” good or service to the customer. In this context, two criteria must be met for the goods or services to be considered distinct:

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• The customer can benefit from the goods or service on its own or with other readily available resources.

• A good or service must be separately identifiable from other promises in the contract.‍

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3. Determine Transaction Price: This outlines how much the customer will pay, excluding fees from third-parties or tax. It seems straightforward, right? You will still want to consider several variables, including but not limited to:

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• Variable considerations: Instances of discounts, rebates, refunds, credits or incentives.

• Non-cash transactions: Payment in goods, services, stock or other non-cash means.

• Payments back to the customer: When a company must also pay the consumer — buydowns, price protection, coupons and rebates.

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4. Allocate the transaction price to the performance obligations in the contract: If a contract has more than one performance obligation, a company should allocate the transaction price to each separate performance obligation based on its relative standalone selling price.‍

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5. Recognize revenue when (or as) the entity satisfies a performance obligation: Once both parties have followed through on the contracted obligations, a company can proceed with recognizing this revenue.

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How Zeni can help you with revenue recognition

Whether you're running a brand new startup or looking to grow quickly, compliance with the revenue recognition principle will help ensure the health of your business now and in the future.  

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As a full-service finance firm, Zeni can help you better understand the hidden nuances and steps behind proper revenue recognition, accounting, tax, and CFO services at a set monthly fee based on how much you spend to run your business.

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Forget spreadsheets and trying to navigate complex analytics. Get started with real-time visibility into your company finances today.

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