Revenue recognition is a process for reporting revenue by recognizing the monetary value of a transaction or contract over a period of time. The amount of revenue that is recognized must match the actual benefits a company obtains from the products or services provided. It is one of the most fundamental accounting methods, impacting the profits and losses reported on an organization's income statement, which is used to report on financial performance and is key to investor reporting.

Revenue recognition rules are determined by the Financial Accounting Standards Board (FASB), the SEC, and other regulatory agencies. The principle of revenue recognition is an essential part of accrual accounting, which differs from cash accounting in that it recognizes revenues when the transaction has been completed by delivering the good or service instead of when cash is received. Cash-basis accounting, by contrast, recognizes revenue only when cash changes hands.

Revenue Recognition Criteria

The revenue cycle refers to the sequence of events during a billing period that leads to the creation of an invoice and payment from that invoice. The process begins when a sale is made and ends when cash is received. This process involves both accounting and business processes.

Businesses may find it difficult to define what constitutes a sale, which is why they should clearly outline the terms of exchange with their customers. During the process of providing a service or selling goods to customers, an extended period may pass. But businesses can still request payment as soon as they have produced and delivered the goods or service—provided they have proof that they have fulfilled their end of the bargain.

The following criteria need to be met for revenue to be recognized: 

• Evidence of an arrangement exists 
• The risks and rewards of ownership transfer from the seller to the buyer.
• Delivery has been made or services have been rendered
• The seller's price is fixed or determinable 
• The revenue generated can be measured with a high degree of accuracy.
• Collectibility is reasonably assured

Why Is Revenue Recognition Important?

The correct accounting for revenue is essential to the preparation of reliable financial statements. Investor perception of a company’s performance is primarily based on the firm’s revenue. 

Investors consider several financial metrics when determining whether a company is profitable. Investors analyze company profitability using a number of financial metrics. Revenue recognition makes it possible for a company's financial statements to accurately portray its operational performance.

Revenue recognition is important since it is the primary measure of a company's results. Once revenue has been recognized, it is crucial to present accurate information regarding business transactions for which revenue has not yet been recognized.

Five-Step Model for Recognizing Revenue – ASC 606

Revenue recognition is a complex topic for businesses of all sizes, especially when it comes to applying the new FASB standards. The new standards are complex because they require companies to change their thinking about how to record revenue and when to recognize it.

Many companies use the five-step model for recognizing revenue, which determines how to account for changes in transaction prices.

Identify Contract With Customer 

The first step of a contract is to make sure all the parties involved agree on what they are committing to. This means that everyone must agree on the rights and obligations of each party, as well as payment terms for goods or services that are going to be transferred.

A buyer's agreement to pay a certain price when due is unconditional. There are no stipulations in the contract that state payment depends on fulfilling certain conditions

Identify Performance Obligation(s)

A performance obligation is a promise in a contract to transfer a good or service to the customer. If you have multiple performance obligations in a contract, make sure that each is distinct from the others.

When determining whether goods or services are distinct, it is important to consider the following conditions:

• The customer can benefit from the goods or services on their own.
• The good or service must be identifiable in the contract.

Businesses often recognize revenue for the full amount of an unconditional promise for those goods or services in the same period when control over the good or service is transferred to the customer.

Determine Transaction Price

The transaction price is the cash amount a seller and buyer agree on for a sale. It's usually determined by contract and written into the agreement. The seller will receive a fixed amount of cash for their goods or services, but in some cases, the seller will also collect sales tax on behalf of a governing entity.

Allocate Transaction to Performance Obligation(s)

When a contract has more than one performance obligation, the seller should allocate the transaction price to each of those obligations based on its standalone selling price. If a contract has more than one obligation, and the seller determines that any of those obligations are not distinct, the seller should allocate the transaction price to each separate performance obligation based on its standalone selling price.

Recognize Revenue As Performance Obligation(s) is Satisfied

When you recognize revenue, you must consider the entire transaction. Revenue recognition is based on transferring goods, services, or rights to customers in exchange for cash or other assets.

Revenue can be recognized at a point in time or over a period of time. Revenue is recognized when:

• The customer gains control over the product or when the service is received;
• The seller's performance obligation is complete; and
• The payment is reasonable collectible

Revenue Recognition for SAAS

The Software as a Service (SaaS) subscription model provides predictability and repeatability, and the usage-based pricing model allows customers to pay per use and aligns better with customers’ buying behavior and greater customer retention. Both pricing models can be great for growing a company, but there are some challenges in allocating revenue and expenses. The process for recognizing SaaS revenues can be more complicated than recognizing other types of revenue, but the reasons why are understandable. Typically, access to a software program is paid in advance of its use. A SaaS business gets paid in advance for its software, which is accessed throughout the contract period.

Why is SaaS Revenue Recognition more complex?

Accounting for SaaS is complicated because there are so many ways that customers can engage with products. When customers can buy upgrades, downgrades, and service bundles, it becomes even more challenging to keep track of accounting with large volume transactions. On the other hand, usage-based pricing charges customers based on how much they use, so that revenue is variable and determined by the number of resources used. Every transaction with SaaS products is different, which makes accounting for SaaS more complex than many other types of businesses, especially when you add usage-based pricing and hybrid pricing models to the mix.

The SaaS revenue recognition process can become complex when one or more of the following occurs:

• The company has multiple fee structures for different types of customers (e.g., one-time payments vs. monthly plans)
• The company offers products at varying prices, depending on features and other characteristics
• The company provides the opportunity to upgrade during a contract period that does not require an additional commitment from the customer

SaaS business providers offer a variety of pricing plans, including usage-based, tiered pricing, hybrid, or dynamic billing. It is necessary to analyze each combination of revenue recognition rules with your specific situation to ensure that you are using the most appropriate method for each element of your revenue. Because of the complexity of the accounting rules in this area, it can be difficult for companies and their audit committee members to determine whether revenue was properly recorded.

Conclusion

Proper revenue recognition is vital as it directly affects the accuracy of a company’s financial reports. When the company complies with all the rules of revenue recognition and guidelines for ASC 606, it gets a full picture of its performance. Talk to a LogiSense expert today to see how we can help you meet your revenue recognition goals.