Revenue recognition is an accounting principle that determines when an organization acknowledges its revenue and expenses, and is especially applicable for subscription business models and SaaS brands. Under revenue recognition standards, organizations count revenue when it is earned, before actual payment is made. This runs counter to cash accounting methods that only recognize revenue once money is received.
At the most basic level, revenue is simply the money your company makes from its business activities—the income from sales or services. Revenue recognition standards place income into four distinct classifications. Where revenue falls in these categories depends on how and when it’s received.
Accrued revenue is income that has been earned, but not yet received. This most often applies to companies in the service industry, and rental income. Once services are rendered and billed, the revenue is considered “accrued” until it is received. At that point, it becomes realized revenue. The amount is then deducted from the accrued revenue entry on the balance sheet, and included in the appropriate place on the income statement.
Deferred revenue is income that you have received for goods or services not yet delivered. This is a significant consideration for subscription and SaaS companies, as most take payment from customers on monthly or annual bases, before product or service delivery is complete. These types of revenue and transactions vary based on contract dates, lengths, and terms.
A common example of this kind of revenue is the prepayment of annual subscription fees. Deferred revenue is considered a liability on the balance sheet because you still owe the customer something. If you can’t deliver, a refund must be issued and you lose that revenue. Once you have delivered the goods or services, deferred revenue is realized and converted into an asset.
Realized revenue is income that the organization has received. In many cases, revenue is only realized when payment is made. In other instances, you can realize revenue as soon as the customer agrees to purchase the item or service in some official manner, such as by signing a contract. When analyzing received revenue, subscription companies who want an accurate view of their profitability must dig even deeper and look at:
Realized revenue is different from realizable revenue, which is income that hasn’t been received but is reasonably expected to arrive in the near future. Realizable revenue for a subscription company includes the amount you have billed but not yet received for next month or next year’s contracts.
Advances such as deposits are considered liabilities. Like deferred revenue, they can’t be realized and counted as assets until they have been paid in full, and you have rendered the service or delivered the goods.
Transactions are the business dealings that bring revenue into your organization. Although most transactions fall under sales and services, there’s a third type that you must account for under revenue recognition standards.
The Sale of Inventory and Assets
There are two different ways to recognize revenue from a sale, depending on whether the item is considered inventory or an asset. When selling inventory, the revenue is recognized on the date of delivery, regardless of the date of sale. For assets, such as subscriptions to a service, the revenue for a sale is recognized when the sale takes place.
There are exceptions to this rule, however. If your company offers buyback agreements or warranties on goods and services, any income you receive from the sale can’t be recognized until the warranty period ends.
For services, revenue is recognized when the work is completed and invoiced. Although the payment may not be due for 15 to 30 days or more, the income can still be counted once you send the bill. If a customer has provided a payment method such as a credit card, you may charge it at this time.
Permission to Use Company’s Assets
The way revenue is recognized when another entity uses your company’s assets is different from both of the above transactions. This applies to interest from loans your company provided, royalties, and rental income. In these situations, the income is recognized as the asset is used. For example, royalties are realized once the work they are associated with is published, while rental income is realized with each monthly payment.
Generally accepted accounting principles exist to help maintain financial transparency and integrity. Although the SEC doesn’t require private companies to follow GAAP, the principles provide a standard way for collecting and recording financial data. To meet GAAP requirements, revenue must meet certain criteria before it can be recognized:
You can collect income in two ways under revenue recognition standards. Both approaches eliminate disparities in how revenue is counted, but each only applies to specific situations.
The Critical Event Approach
This method requires that a sale meet five qualifications before you can recognize the proceeds as revenue:
Beyond these five qualifications, additional conditions have to be met, depending on the product or service being sold:
The Accretion Approach
The accretion approach mostly applies to companies that work with commodities, such as precious metals, timber, and agricultural products. With the accretion approach, companies can recognize revenue when the commodity is collected instead of when it is sold. This only works in stable markets with reliable sales prices and uniform, homogeneous units. In addition, the cost of marketing and advertising the product must be low and have little effect on the sales price.
By accounting for revenue and expenses using these revenue recognition standards, businesses can accurately match their revenue-generating tasks with the income and expenses for those activities. Under this system, contemporary subscription or Saas companies are able to construct a more uniform, comprehensive representation of your company’s finances.