When a company generates a sale, the revenue earned must be recorded and added to the income statement. Many finance managers face the challenge of knowing exactly when to recognize revenue, as it's not based on when money is received.

This is where the revenue recognition principle comes into the picture. This principle dictates that specific conditions must be met in order for a company to record the revenue from a sale. Accountants understand that revenue recognition plays a pivotal role in accrual accounting, which is part of the generally accepted accounting principles (GAAP).

In this guide, we’ll explain the components of revenue recognition, highlight how it can impact your scaling business, explore which revenue recognition model you should use, and review an industry case study.

Table of Contents

1. The conditions of revenue recognition
2. The importance of revenue recognition
3. The challenges finance teams face when recognizing revenue
4. Determining which practice to use
5. Revenue recognition compliance guidelines
6. Case study of revenue recognition: IFRS vs. ASPE
7. Scaling revenue recognition practices with QuickBooks
8. FAQ

The conditions of revenue recognition

In recent years, the International Financial Reporting Standards (IFRS) and Financial Accounting Standards Board (FASB) established the following five-step framework to determine when to recognize revenue:

Accrual accounting vs. cash accounting

There are two main accounting methods companies use: accrual-based and cash-based accounting. Here's a breakdown of each.

Accrual method

The revenue recognition principle falls under the umbrella of accrual accounting. This accounting method recognizes revenue at the moment it’s earned, not when a business receives payment.

You must report the income in the fiscal period when it is earned, regardless of when you receive the actual payment.

Larger, medium-sized businesses, and public companies must use accrual accounting because it complies with GAAP. Although it requires more detailed bookkeeping, it provides a more accurate reflection of a company’s financial well-being.

Cash method

In contrast, cash accounting recognizes revenue specifically when the cash payment is received, even if the goods or services haven’t been delivered yet. Moreover, expenses are usually recognized at the time they are paid.

Cash basis accounting is easier to manage than accrual accounting, but it may not precisely portray the financial health of a business — particularly for larger-scale enterprises with elaborate operations. Generally, small businesses or independent business owners use this method. Note, however, that it is not compliant with GAAP.

The importance of revenue recognition

On the surface, revenue recognition may seem straightforward. But depending on the product or service your company provides, it may cause unexpected challenges that impact financial reporting. So it’s essential for medium-sized businesses to lay a foundation of comprehensive practices and transparent policies for revenue recognition.

How stakeholders use financial reports

Following a standardized revenue recognition principle allows external stakeholders, like potential investors and analysts, to review and compare financial statements of similar companies and evaluate their financial health.

When financial analysts review total revenue and make valuations, it can significantly impact a company’s stock price as well as its ability to obtain a loan, secure investments, or close a merger and acquisition deal.

Mid-sized companies that effectively execute these measures can maintain regulatory compliance that meets accounting standards, ensure accurate representation of a company’s financial performance, and build trust with stakeholders.

The challenges finance teams face when recognizing revenue

Finance professionals must perform a balancing act when it comes to revenue recognition. An overestimate or underestimate of revenue recognition during a specific period could impact the company’s success.

For example, if excess revenue is documented, the operations team may think it has excess funds to purchase new equipment. This may result in overspending, jeopardizing the company’s cash flow.

On the other hand, if a company receives more payments than anticipated due to under-recognizing revenue, it might forego helpful resources that could have been used to accelerate the company’s growth.

Finance managers should use superior judgment when recognizing revenue for the company.

Determining which practice to use

The type of business you operate, which stakeholders are involved, and where your operations are located are all important factors that will determine which accounting standard to implement in your business. 

Private companies or not-for-profit organizations in Canada

If you operate a private business or not-for-profit organization, follow the Accounting Standards for Private Enterprises (ASPE), which were developed by the Accounting Standards Board (AcSB).

Owners, buyers, creditors, lenders, credit rating agencies, and suppliers are the key stakeholders interested in viewing a company's financial report using the ASPE model.

Considerations when using the ASPE framework

ASPE has a simplified framework compared to IFRS. In addition, the AcSB factored in the unique needs of Canadian private companies when it developed this framework.

These are the advantages of using ASPE's model:

• It provides more flexibility compared to IFRS 15.
• There are fewer disclosure requirements.
• It may be more cost-effective compared to IFRS.

ASPE or IFRS: Which practice should you choose?

Here are a few examples of how a company can determine which framework is best suited for its needs.

Scenario #1: A medium-sized company that has a potential domestic lender who doesn’t require GAAP financial reporting can be compliant using ASPE. 

Scenario #2: A growing business that’s planning to build new retail locations across Canada and needs $5 million worth of manufacturing equipment will likely have its bank request a formal audit that incorporates proper financial reporting frameworks using IFRS.

Public companies in Canada

The AcSB mandates that Canadian public companies use IFRS to prepare all financial statements. As such, a public company in Canada should follow IFRS, which is issued by the International Accounting Standards Board (IASB).

Currently, public companies in over 168 jurisdictions globally use IFRS accounting standards.

Considerations when using IFRS 15

Revenue recognition is outlined under IFRS 15 and follows a five-step model, detailed below.

The main focus is on the following 3 areas:

• Contract identification
• Performance obligations
• Recognizing revenue when the goods or services have been transferred to the customer

IFRS provides clear and consistent guidelines that help investors compare companies worldwide. If you’re seeking global investors, you’ll need financial statements that adopt IFRS accounting standards.

The one drawback to using IFRS is that it can be more complex than ASPE, as it requires more detailed information regarding in-progress contracts. Companies may need to seek professional advice on how to apply IFRS to their financial reporting process. 

Canadian companies listed on U.S. stock exchanges

Canadian enterprises that are listed on the U.S. TSE 300 and that have American investors can choose between IFRS 15 and the U.S. GAAP (ASC 606), depending on their filing status.

Foreign private issuers

Most Canadian companies have a foreign private issuer (FPI), which means a non-American company conducts business in the United States. If this applies to you, you can choose to report under IFRS or U.S. GAAP (ASC 606). Since these accounting standards are similar, companies can align their reports to cover both the Canadian and American markets.

Domestic U.S. issuers

In contrast, a Canadian company that has a domestic U.S. issuer (meaning it is registered with the U.S. Securities and Exchange Commission, or SEC) typically must follow U.S. GAAP (ASC 606) for financial reporting. 

It’s important to note that private companies that plan to go public may need to make adjustments to their revenue recognition policies and practices.

Pro Tip: QuickBooks Online Advanced has built-in revenue recognition features equipped to handle various accounting standards. With our diverse range of forecasting and reporting tools, mid-sized businesses can effortlessly track deferred revenue, improve financial transparency, and comply with reporting regulations. Leverage QuickBooks to streamline your revenue recognition process, gain clear financial insights, and produce accurate financial reports. 

Revenue recognition compliance guidelines

Now that you understand which accounting standard to adopt within your organization, the next step is to review the systematic procedure to recognizing revenue.   

IFRS 15 & U.S. GAAP (ASC 606) revenue recognition

The Finance Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) collaborated to establish a single framework that can be used across industries and countries.

The following five-step model is the joint effort of the two accounting boards. You can find extensive details about this particular revenue recognition model here, but here’s a quick overview:

1.Identify the contracts with a customer.

A contract is created to establish obligations and each party’s rights. It must be approved by all parties involved, and they need to commit to fulfilling their obligations.

The contract should outline transparent payment terms, have commercial substance, and state the probability of collecting payment. A supplier must combine multiple contracts into one contract if they share a business objective or if the pricing is interdependent.

2.Identify the performance obligations in the contract.

Performance obligations are the distinct products or services promised to the customer.

The product or service should provide stand-alone value and can be transferred separately. It should also outline extra services like free shipping, or added services like warranties, as well as return policies.

3.Determine the transaction price.

This is the expected total amount, which includes fixed and variable considerations, financing components, non-cash considerations, other deductions (such as rebates, credits, incentives, or refunds), and non-refundable fees.

These estimates should align with anticipated revenue while taking into consideration the limitations on variable amounts.

4.Allocate the transaction price.

Typically, the transaction price is allocated to each performance obligation, which is based on the stand-alone selling prices. There can be exceptions for specific discounts and other considerations.

Prices can be estimated by using the three commonly acceptable methods, including market assessments, the expected cost-plus margin, and residual approach.

5.Recognize revenue when a performance obligation is satisfied.

The revenue is recognized when the good or service is transferred to the customer. This can take place at a specific point in time, or it can be satisfied over a period of time.

Companies can track their progress by using the input method (such as the number of hours or quantity of materials used) or output method (such as the number of products delivered).

Remember, it’s important to stay up to date with the latest accounting standards, as they may change over time.

ASPE (Section 3400) revenue recognition

Revenue recognition is outlined under ASPE (Section 3400). However, unlike the IFRS & GAAP 5-step model, ASPE doesn’t have a formal structure.

Instead, under ASPE, performance obligations are treated as a single obligation and revenue is recognized at a point in time, such as the delivery of a good or service to the customer. Additionally, ASPE requires only minimal disclosures, whereas with IFRS and GAAP, companies must provide extensive disclosures.

For more detailed and updated information, consult the CPA Canada website.

Case study of revenue recognition: IFRS vs. ASPE

Here’s a scenario where we’ll compare how revenue recognition is applied under IFRS 15 and ASPE (Section 3400).

A Vancouver-based project management (PM) company sells a 3-year subscription-based software license for $125,000 to a local construction company looking to streamline its operations for multiple commercial development projects.

The PM company also provides VIP customer support as an added service for the duration of the subscription. The construction company agrees to pay the entire amount at the start of the agreement.

Now, the PM software company must decide which revenue recognition standard to use.

If it’s a public company, it will use IFRS 15. If it’s a private company, it will use ASPE (Section 3400).

Let's examine both methods.

First method: Public company using the IFRS 15 approach

Here’s what the PM software company should do under the five-step model:

Step 1: Identify the contract with the customer.

A signed agreement is created between the PM software company (the seller) and the construction business (the customer).

Step 2: Identify the performance obligations in the contract.

The contract has two distinct performance obligations:

• A project management license that grants the right to use the software.
• Prioritized customer support to offer continuous service for 3 years.

Step 3: Determine the transaction price.

The total price is $125,000. The entire balance was paid upfront and in full by the construction business.

Step 4: Allocate the transaction price to the performance obligations.

The company determines the fair market value in the chart below:

Step 5: Recognize revenue when the performance obligations are satisfied.

For this final step, here’s how the PM software company will recognize the revenue in the ledger for the following 3 years.

Year 1:

The software license revenue of $89,000 is recognized right away because the control is transferred to the customer at the start of the contract.

The customer support revenue of $36,000 is recognized equally over 3 years. This amounts to $12,000 annually ($36,000 / 3 years = $12,000).

Thus, the first year of customer service is debited as an accounts receivable, and the second and third years of customer service are credited, as these revenues are deferred. 

Year 2:

In the following year, the PM software company provides customer support to the construction company. Once this performance obligation is complete, it's considered earned revenue.

Remember, even if the construction company hasn't issued the payment, it's still regarded as earned revenue.

Year 3:

In the final year, the same process applies. When the customer support has been completed, it's recognized as revenue. 

Second method: Private company using the ASPE (Section 3400) approach

There are two considerations when using the ASPE method:

• The PM software company isn’t required to divide the contract into separate performance obligations.
• Revenue is generally recognized when performance is substantially complete.

With this in mind, if the company believes the contract is a single obligation, it can recognize the $125,000 upfront because the customer paid and has immediate licensed access to the project management software application.

However, if the company deems that VIP customer support is a separate performance obligation, it has the ability to distribute the revenue over 3 years.

Keep in mind that ASPE isn’t as strict as the five-step model under IFRS. Thus, this complex method isn't necessary.

There are two possible outcomes:

1. In the first outcome, the entire $125,000 is recognized immediately if it’s seen as a single performance obligation. This is the preferred and straightforward way of recognizing revenue.

2. The second outcome is to recognize $89,000 upfront. The project management software company can defer $36,000 over 36 months (3 years x 12 months = 36 months) if they consider the customer support service as a separate performance obligation. This works out to $1,000 monthly ($36,000 / 36 months = $1,000 per month). Using this method requires more calculations and bookkeeping.

Putting revenue recognition into practice requires thoughtful planning and execution. QuickBooks Online Advanced provides revenue recognition tools to help your finance team access a comprehensive view of your business financials. Your team can set it up to automatically move revenue from liability to asset on your predetermined schedule. 

Scaling revenue recognition practices with QuickBooks

While revenue recognition may seem complicated, it ensures transparent financial reporting and builds credibility with stakeholders. By implementing clear policies and procedures, CFOs and finance teams can help formulate an accurate financial analysis and facilitate proper forecasting.

Whether you sell goods or services, QuickBooks can help you easily track your deferred revenue and fixed assets. With these tools at your fingertips, you can view accurate real-time financial reports and access fine-tuned revenue forecasts to help your team make informed business decisions.

Grow your revenue faster with QuickBooks Online Advanced. Discover how QuickBooks’ all-in-one financial hub can help streamline your revenue recognition and boost your bottom line.

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