Revenue recognition principle: Basics, considerations & tips

When managing finances, knowing when to document your business-related earnings ‌can be tricky. According to the revenue recognition principle, executives should record revenue once a product or service is delivered to a customer. 

This completion-based approach allows mid-sized businesses to align financial reporting with actual sales performance, which provides a more reliable representation of revenue over time. It’s an accrued revenue method that’s most common when clients pay after the completion and delivery of a service. Let’s dive into the ins and outs of how this principle applies to an executive team.

Jump to:

• Understanding the revenue recognition principle
• Revenue recognition accounting considerations
• GAAP vs. IFRS requirements
• ASC 606: The 5-step revenue recognition model
• Examples of revenue recognition
• Best practices for applying revenue recognition rules
• Boost productivity and enhance profitability
• Revenue recognition principle FAQ

Understanding the revenue recognition principle

Revenue recognition accounting creates consistent reporting across diverse industries. This is ideal for benchmarking against competitors as well as global operations. 

Rather than recording income when cash is received, the revenue recognition principle says businesses should record earnings after completing a service or the delivery of goods. 

If project-based accounting or ongoing services are common deliverables in your industry, this type of accounting can help prevent over or underreporting income by instead focusing on your business’s productivity. 

Revenue recognition accounting considerations 

The revenue recognition principle is an overarching concept that bundles smaller considerations together. It is based on accrual accounting, the matching principle, and recognition timing. When these components are understood, it’s easy to reconcile your financial statements.

Here’s a rundown of the various elements that make up the revenue recognition principle:

Accrual accounting basics

Accrual accounting is the underlying philosophy of the revenue recognition process. It’s based on the principle that accrued revenue and expenses are only documented when earned or purchased. It provides an accurate timeline of services within a certain period, so companies can track their financial inputs and outputs no matter when the actual payment is issued. 

When revenue and expenses are notated within the same period, it is easier to see a business's profits, losses, and overall financial health. Not only is this internally helpful, but it also clarifies your accounting for investors, lenders, tax authorities, potential buyers, and auditors. 

Matching principle relationship

The matching principle ensures that revenue and expenses are recorded within the same month, quarter, or year. Much like the revenue recognition rules, it’s helpful for service-based or ongoing projects with complex transactions that occur at different times.  

Recognition timing 

Recognition timing refers to when a product or service-based deliverable is achieved. This satisfies an obligation—a contractual agreement to provide a deliverable for a customer. It doesn’t necessarily correlate with the agreed-upon payment date. 

Industry considerations 

Since different industries have different deliverables, there are specific considerations to keep in mind depending on your organization’s structure and services:

SaaS

Calculating accounting revenue recognition can be challenging for companies offering subscription-based software and SaaS programs. If the consumer purchases a one-time license, the business can record revenue at the time of the sale. If your software requires installation, customization, or integration with other products, it’s considered an implementation service, and you'll record earnings when you complete your service.

For ongoing SaaS charges, support services (such as a dedicated customer support team) and account management are recognized on a straight-line basis, meaning there is a set recurring fee. 

Construction

Many construction companies use the percentage of completion method to recognize revenue on long-term projects. In this method, organizations determine milestones while negotiating a project, often coupled with progress billing. In this scenario, revenue is recognized each time a portion of the bill is sent to the purchaser. If a contract needs an adjustment during the project, this needs to be noted to maintain a revenue recognition accounting standard.

Manufacturing

When it comes to manufacturing, consider product warranties, as there may be future costs to account for. You need to be careful not to overstate recognized revenue if the consumer has a right to return the product. Bill-and-hold situations where the product has been sold but has yet to be delivered require the revenue to be recognized when the buyer takes ownership. 

The Intuit Enterprise Suite offers a custom ERP solution tailored to these industry-specific needs. This way, executives can rest assured that everything is correctly accounted for. 

GAAP vs. IFRS requirements

Both GAAP and IFRS have revenue recognition rules and guidelines, but GAP has a more stringent outline, whereas IFRS is more flexible. 

Generally accepted accounting principles (GAAP)

GAAP is primarily used in the United States and encourages transparency in financial reporting. Here are the stand-out aspects of GAAP guidelines: 

• Makes the revenue recognition process clear and easy to follow but reduces flexibility for businesses
• Requires clear documentation and validation of the delivery of goods
• Offers industry-specific guidelines, which are useful in sectors where it's crucial to keep detailed reporting, such as retail-based organizations

The biggest challenge with GAAP is adhering to all the requirements Enterprise accounting software simplifies this by automating revenue recognition and maintaining compliance.

International financial reporting standards (IFRS)

IFRS is a global standard that aims to find commonality for easy-to-compare requirements across various countries. IFRS is a set of general principles rather than strict rules. Since IFRS is more flexible, adhering to it can be more confusing and lead to inconsistent reporting.

ASC 606: The 5-step revenue recognition model

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) reduced 100 guidelines into one streamlined set of 5 steps to create a universal guide for revenue recognition.

Since 2017, this guide, or Accounting Standards Codification 606 (ASC 606), has been mandatory for public businesses. It follows the revenue recognition principle, which is important to know when choosing transaction methods.

 Here’s a brief review of each one:

1. Identify customer contract

A customer contract helps sellers and buyers agree on the terms of a sale. A business must have clear details concerning what is being sold, its price, and when it will be delivered. To be legally sound, a contract must align with regional laws, and the document must be signed and maintained. A contract should clearly name specific roles, responsibilities, and conditions.

2. Identify performance obligations

A merchant needs to clarify any specific promises made to a customer. A business needs to decide to either bundle goods and services or make unique contracts for individual goods and services. You can use separation criteria to decide what offerings naturally go together.

For example, a cell phone purchase may come with a year-long warranty and technical support, which may add to the overall value of the sale when combined.

3. Determine transaction price

Determining a transaction’s price involves considering several different factors. Variable consideration refers to the possibility that price may change depending on certain outcomes, like meeting a sales goal or achieving a performance bonus. 

The time value of money indicates that currently, available money is more valuable than money in the future since it has the potential to bear interest. Noncash consideration represents any exchange for goods and services outside of a cash payment. 

There are several methods to calculate these values, which ultimately determine the transaction price of goods and services, ensuring they are fairly valued. 

4. Allocate transaction price

The standalone selling price is the price of each item if sold separately. This price is used to determine the allocation of the transaction price. This form of itemization ensures fairness, accuracy, and transparency in pricing. 

It also helps customers understand the value of a purchase in complex situations, such as a bundle that contains a physical item, a service, and a subscription. 

5. Recognize revenue

The final step of this model involves determining the exact amount to be recorded from a sale, as well as the exact time it should be notated. When it’s best to recognize revenue it depends on the transfer of control of the asset. 

Progress measurement allows businesses to track products or services that are provided over an extended period with incremental completion milestones. 

It’s important to maintain clear records of terms and details, project progress, and payments to make sure that revenue records truly reflect what transpired between a business and a purchaser. Investing in reputable enterprise software supports executives with multi-entry management. 

Examples of revenue recognition

Here are practical, real-life examples of implementing this principle in compliance with ASC 606. Assuming they follow the 5-step model, they carefully consider the terms, conditions, pricing, and sale value. 

• Simple product sales: When a home improvement store sells shelving to customers, revenue is recognized once the buyer exits the store with the item.
• Service contracts: The revenue is recognized after each session if a commercial cleaning company provides a weekly service.
• Subscription revenue: A streaming music company can recognize monthly or annual revenue as a user’s subscription renews. 
• Installation services: When an HVAC system is installed in a home, the technician can recognize revenue when the installation is finished and the system is usable.

Best practices for applying revenue recognition rules

Let’s tie everything together into a concise set of best practices that help decision-makers choose accounting methods that work best for keeping midsize and enterprise-level companies in compliance:

• Manage multiple deliverables properly with detailed documents establishing how each item is transferred to the buyer.
• Document contract modifications and take note of their overall effect on pricing and overall timelines. 
• With international transactions, research and stay updated on region-based compliance requirements. 
• Establish an approval process that reinforces accuracy and consistency in your revenue recognition systems. 
• Create audit trails that make verification easy if there are any discrepancies.

These guidelines can ensure compliance and accuracy when opting for revenue recognition accounting. 

Boost productivity and enhance profitability

A centralized and well-organized system is key to effectively implementing a revenue recognition accounting system that helps companies maintain compliance with ASC 606. Intuit Enterprise Suite offers these tools so mid-sized businesses can confidently handle accounting.