For most businesses, revenue recognition is far simpler in theory than in practice. The day-to-day reality of running a business introduces layers of complexity. When you consider common features such as tiered pricing, prorations, product or service bundling, and dynamic payment options, revenue recognition guidelines can become confusing.
Here's what you need to know about why revenue recognition matters, the different methods businesses can use to create accurate revenue reporting, and how Stripe's built-in revenue recognition solution can make it easier.
What's in this article?
- What is ASC 606 revenue recognition?
- Why revenue recognition matters
- Choosing a revenue recognition method
- What are the revenue recognition methods?
- How to make revenue recognition easier
What is ASC 606 revenue recognition?
ASC 606 is a set of standards and practices that govern how businesses approach revenue recognition. The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) issued ASC 606 in 2014, and businesses around the world and across industries recognise and use it. As a business, you must operate under these specific rules and regulations when calculating and reporting your revenue.
ASC 606 provides a flexible, five-step framework for recognising revenue, including the amount and timing, which simplifies financial statement preparation. Here's a brief rundown:
1. Identify the customer contract
This specifies the criteria that a business must meet when creating a customer contract to supply goods or services.
2. Specify performance obligations in the contract
This describes how the business will fulfil the specific performance obligations listed in the contract.
3. Set the transaction price
This details what factors a business must consider when determining the transaction price (the amount your business expects in return for issuing the customer the goods or services).
4. Allocate the transaction price
This lists the guidelines used to allocate transaction price across your contract's distinct performance obligations and what the customer agrees to pay for each.
5. Recognise revenue when, or as the entity satisfies a performance obligation
This specifies how you'll recognise revenue as your business meets each distinct performance obligation.
Why revenue recognition matters
A GAAP ("Generally Accepted Accounting Principle") in accrual accounting, ASC 606 revenue recognition identifies the circumstances or conditions in which business revenue is recognised and indicates how it must be accounted for. It states that:
- Revenue is recognised when it's acquired or earned and customers have received goods or services in full, rather than when payment is received.
- Reasonable assurance is required that the revenue earned will be received.
- Revenue and any associated costs will be reported in the current accounting period.
Sales revenue is one of the core markers by which business success is measured, which means there are a number of reasons why a business might want to structure their accounting practices in a way that depicts the most favourable revenue scenario possible. This, of course, can result in a misleading picture of earnings and company valuation, which has implications for shareholders and customers. Even if a business isn't intentionally misleading others with their revenue recognition practices, it's possible that their accounting methodology is flawed, thus resulting in confusing or inaccurate fiscal reports that might not convey the key information that business leadership and shareholders need to know.
There are many reasons why a business might use a subpar approach to revenue recognition, which is why it's important that every business takes on this task according to standardised policies and guidelines. These guidelines help create consistent financial benchmarks between companies in the same industry, as well as providing historical financial information for a company over time, allowing for an understanding of inconsistencies and trends. These accounting principles give the broader business world a shared language with which to examine the financial statements of any company.
Choosing a revenue recognition method
There are pros and cons to each revenue recognition method, so it's important to understand what they are along with various use cases and implications before choosing one for your business. Keep in mind that revenue recognition includes not only how revenue is recorded, but also how you identify and allocate costs incurred in obtaining and fulfilling contracts (e.g., sales commissions, labour and materials).
Your specific industry, business, business model and contractual obligations will help determine the right revenue recognition method for your business. The correct choice will be the one that most accurately illustrates your business's financial reality. When choosing a method for recognising revenue, it's important to understand the "performance obligations" of your business and how they're delivered as defined by ASC 606.
Choosing the wrong method can easily deflate or inflate your financial information, including revenue, profits and expenses. This can lead to poor decision-making, more tax liability and diminished confidence from investors. Revenue recognition is a complex and high-stakes aspect of running a business, which is why you should not only align your accounting team with the best strategic approach, but ensure that your tech stack is intelligently optimised to consider the complexities of revenue recognition.
What are the revenue recognition methods?
Even though every business uses ASC 606 as a framework for revenue recognition, there are several different methods to recognise income as revenue on financial statements, as outlined below and in these revenue recognition examples.
1. Sales-basis
With the sales-basis method, revenue is recognised when a sale or transaction occurs. This is most common in retail, since a customer can walk into a store, make a purchase and walk out with that purchase, so it makes sense to recognise revenue then and there. Or, for instance, if a customer subscribes to your software's monthly plan, with a year-long commitment, and the total value of that contract amounts to $2,400 over the course of the year, you would recognise the revenue earned as it happens. That means you earn £200 each month, even though the customer commits to paying £2,400 in total throughout the life of the contract.
It's important to note that this method considers a transaction complete when the goods or services have been delivered to the customer, not when payment is received. Sometimes these two things happen at the same time, but your revenue recognition rules should be based on when the obligation is fulfilled, not when payment is received.
2. Percentage of completion
Businesses that work with longer-term or large contracts – for example, commercial construction – commonly use the percentage of completion method of revenue recognition. Even when a project is still in process, these businesses need to prove they're creating revenue, and do so by designating indicators or milestones to show contract progress. Revenue is allocated to those milestones as they're completed throughout the project. Businesses can also use this method based on the costs incurred as contracts move forward towards completion.
The percentage of completion method allows revenue to be recognised closer to real time, instead of only at the end of a contract. This means your financial statements will show more consistent, predictable revenue with fewer spikes and dips.
When using this method, make sure that you're writing enforceable contracts by your jurisdiction's law that have offerings with clear, quantifiable progress indicators. You can also use this method to recognise revenue by cost. For example, if a project's cost is £30,000, you can assume it's 50% complete once the cost incurred is £15,000.
3. Completed contract
The completed contract method recognises revenue only upon contract fulfilment, when obligations are complete. For instance, if you sell 600 chairs to a client and ship them in 3 shipments of 200 chairs in 3 different accounting periods, the contract won't be considered fulfilled until the last shipment is received, in the third period. The revenue from the entire contract will be recognised during the account period when the final shipment is delivered.
This method, which ensures revenue recognition in the correct accounting period, is often used for shorter-term projects, or longer-term projects that can't use percentage of completion because there are no progress indicators. The completed contract method might not be ideal if your business offers a longer-term return window or extended warranty, since you might be dealing with transactions in different accounting periods.
4. Cost recovery (or recoverability)
The cost recovery or recoverability method recognises revenue once costs are recovered from delivering a product or service. Rather than recording revenue and then offsetting it with expenses, this method involves waiting for contract expenses to first be accounted for and then marking any remaining revenue as income. This method is the most conservative option for revenue recognition and is often used by businesses that experience payment delays or can't estimate the expenses (or cost of goods and services) that will be required for a contract.
5. Instalment
The instalment method is best suited to businesses with customers who pay for goods or services over many months or years, or those that cannot know ahead of time – or even guarantee – when payment will be received. For example, if a customer buys a mobile phone for £1,200 and pays £100 each month for one year, the business recognises revenue of £100 as it's received each month.
This method allows the business to recognise revenue as it comes, since there is always a chance that full payment will not be received.
Other revenue recognition methods include:
- Accrual
With this method, prepayments get recorded first as prepaid assets, and later as expenses, once goods or services are delivered. - Brokerage agreement
This method abides by proprietary rules if a broker clearly works along the IRS and SEC guidelines. - Proportional performance
This is a modified version of the percentage of completion method. - Appreciation
Used mainly by real estate agents, this method allows them to reduce the gain recognised from selling a property at its appreciated value. - Deposit
This method is used for payments held as deposits that are subject to cancellation by either party. - Transactions under bill and hold
This method is often used to exaggerate a company's assets and can be a sign of fraudulent transactions.
How to make revenue recognition easier
No matter what kind of business you're in, it's important that your finance team recognises your revenue correctly, both for compliance purposes and so that you can fully understand how and when your business makes money, giving you powerful, strategic insights into your business. While revenue recognition is a complex topic, managing it for your business doesn't need to be.
Solutions such as Stripe's Revenue Recognition streamline accrual accounting and automate and configure revenue reports to simplify your compliance with ASC 606 and IFRS 15. Stripe's Revenue Recognition effortlessly handles the scenarios that commonly cause accounting complications, such as upgrades, downgrades, prorations, refunds and disputes. With accurate data, you can prepare audit-ready financial statements and gain a comprehensive view of your business.