Revenue recognition methods are the accounting approaches businesses use to determine when and how to record earned income on their financial statements. Under Accounting Standards Codification Topic 606 (ASC 606) – the standard issued jointly by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) in 2014 – all businesses that enter into contracts with customers must follow a consistent framework for recognising revenue. But within that framework, the right method depends on your business model. A retail transaction, a long-term construction contract, and a software-as-a-service (SaaS) subscription each call for a different approach.

Below, we'll explain 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 help 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 Stripe Revenue Recognition can help
  

What is ASC 606 revenue recognition?

ASC 606 is a set of standards and practices that govern how businesses approach revenue recognition. The IASB and the FASB issued ASC 606 in 2014, and businesses around the world and across industries now 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 an outline:

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.

The core principle underlying all five steps is the transfer of control: revenue is recognised when control of a good or service passes to the customer, meaning the customer has the ability to direct the use of and obtain substantially all of the remaining benefits from the asset.

Why revenue recognition matters

Revenue recognition is a GAAP ("Generally Accepted Accounting Principle") in accrual accounting. It 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. It also states that reasonable assurance is required that the revenue earned will be received, and that revenue and any associated costs will be reported in the current accounting period.

ASC 606 sets these rules to ensure revenue and related costs are reported in the correct period, preventing companies from presenting an inflated or misleading picture of their financial health, whether intentionally or through flawed accounting practices. Revenue is a key measure of business success, and without standardised guidelines, comparing companies or tracking a single company's performance over time would be unreliable.

Choosing a revenue recognition method

The right revenue recognition method depends on your industry, business model, and contractual obligations – specifically, how you define and deliver your "performance obligations" under ASC 606. This choice affects not just how revenue is recorded, but also how costs like sales commissions, labour, and materials are identified and allocated across contracts. The right method is the one that most accurately reflects your business's financial reality.

Picking the wrong method can inflate or deflate key financial metrics such as revenue, profits, and expenses. This could lead to poor business decisions, higher tax liability, and eroded investor confidence. Given the complexity and stakes involved, align your accounting team on the right strategic approach and ensure your tech stack can handle the nuances of revenue recognition.

When evaluating which method fits your business, consider these questions:

• Does your business transfer goods or services at a single point in time, or deliver them over an ongoing period?

• Do your contracts contain a single performance obligation or multiple bundled ones?

• Can you reliably estimate the progress and costs of long-term contracts?

• Do your customers pay in full up-front, over instalments, or on uncertain terms?

• Does your business operate under US GAAP (ASC 606) or international standards (IFRS 15)?

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.

Under ASC 606, revenue recognition falls into one of two timing categories: recognised at a point in time (when a distinct performance obligation is satisfied in a single moment) or recognised over time (when a performance obligation is satisfied continuously). The sales-basis and instalment methods below typically apply to point-in-time recognition, while percentage of completion, completed contract, and cost recovery typically apply to over-time or multiperiod recognition.

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. For instance, if a customer buys a US$50 pair of shoes at your store, you recognise that US$50 in revenue immediately, since the sale is complete and the goods have changed hands in that single moment.

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 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, be sure 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 US$30,000, you can assume it's 50% complete once the cost incurred is US$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 three shipments of 200 chairs in three 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 the 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 US$1,200 and pays US$100 each month for one year, the business recognises revenue of US$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.

Additional revenue recognition methods

Other revenue recognition methods include:

• Accrual: With this method, prepayments are 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 Stripe Revenue Recognition can help

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.

Stripe Revenue Recognition helps to streamline accrual accounting – including audits, end-of-month close, reporting, and more – so you can close your books with greater efficiency and accuracy. It automates and configures revenue reports to help simplify your compliance with ASC 606 and IFRS 15. Stripe's Revenue Recognition effortlessly handles the scenarios that commonly cause accounting complications, like upgrades, downgrades, prorations, refunds, and disputes. With accurate data, you can prepare audit-ready financial statements and gain a comprehensive view of your business.

Revenue Recognition can help you:

• Gain a more complete view of your revenue: In the Stripe Dashboard, see all your Stripe transactions and terms, and import non-Stripe data.

• Automate revenue reports: Generate accounting reports that are ready to use – without engineering resources.

• Customise for your business: Create and automate custom rules to recognise revenue, in line with your business's accounting practices.

• Audit in real time: Prepare for audits by tracing any revenue amount down to the underlying customers and transactions.

Learn more about how Revenue Recognition can help you comply with global accounting principles, or get started today.