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The Essential Guide to understand Revenue Recognition

It is often said founders have to wear more than one hat. If truth be told, as a startup founder you would initially be juggling all hats at once. Successful executives know everything about the business they run especially the finances. Yet, most aspiring entrepreneurs seem to be allergic to accounting and rightfully so. Founders are creative people, they shouldn’t be bothered with boring accounting matters. Honestly, even if it isn’t the most interesting topic when you’re starting a business, the success of your business relies on competent accounting. 

No matter what business you run, or what your size is, finance is the lifeblood of your business. While Metric helps you manage every aspect of your business finance and accounting, we still want you to know the basics of accounting. Not only does this equips you to understand your financial reports better, but also empowers you to present your business in a better way. 

Today, we’d be diving deep into the concept of revenue recognition. Since this is specific to accrual basis accounting, let us first find out what accrual accounting is. 

Accrual vs Cash basis Accounting

An accounting method is based on rules that your business must follow when reporting revenues and expenses. Cash basis and accrual basis are the two main accounting methods. The key difference between the cash and accrual methods relates to the timing of revenue and expenses recognition. Both the methods have their benefits and drawbacks. 

Cash basis accounting

Cash basis accounting recognizes revenue when cash is received and when expenses are paid. To further simplify it, according to this method your revenue is the amount that has already been paid to you, the pending payments and expenses don’t count. The reason solopreneurs choose cash basis accounting is because it’s:

  1. Simpler 
  2. Better for small businesses with no employees
  3. No need to journal entries
  4. Tracking accounts payable or accounts receivable not required
  5. Pay taxes on revenue that has already been received

Accrual accounting

Accrual accounting recognizes both revenue and expenses when earned, not when received or paid. What this means is that, when you have delivered a service or product, the decided payment is already recognized as revenue even if you haven’t received it yet. This method provides a much more accurate summary of your business. How? This example would explain it better. 

Accrual Accounting provides a more accurate representation of a company’s finances 

You see two profit loss statements in the pictures above. The one on the left uses cash basis accounting thus not received cash is not shown. Thus the net sales appear to be zero while the cost of goods sold is $2000. This statement shows a loss of $4000. This is not an actual loss but the payments are pending. 

On the other hand, the picture on right uses accrual accounting. It shows net sales of $12,000 for the cost of goods sold $2000, though the payment is not received yet. This statement shows a net profit of $8000, which is accurate once payment is received. This is how this method shows a more accurate picture of the business finances. 

Accrual is considered a better approach for larger companies with more employees. Businesses that extend credit to customers or use credit with their suppliers can attain a more accurate picture of their overall financial health with accrual accounting.

 How does Metric simplifies accrual Accounting?

The only reason businesses hesitate to use accrual accounting is the time and effort required to track and maintain the records. It requires frequent check-ups, tracking of accounts receivable and payable, detailed bookkeeping and manage prepaid and deferred assets. 

Metric does all these tedious tasks for you, and lets you enjoy the perks of accrual accounting. The app lets you see your incoming and outgoing cash on a daily basis keeps a cloud-based real-time dashboard for you to view your financial health, and handles invoices, accounts, bills, payrolls and taxes for its customers. The metric app automates and streamlines the process which reduces errors and staff costs. 

What is Revenue Recognition? 

Revenue recognition is an aspect of accrual accounting that specifies when and how businesses “recognize” or record their revenue. The revenue recognition principle says that revenue should be recorded when it has been earned, not received. When you provide a product or service to a customer, the amount of the created invoice is recorded in your revenue, this is called revenue earned. When you actually receive the payment, that is the revenue received. 

To ensure uniformity in all financial reports, all companies must abide by a defined accrual accounting and revenue recognition practice. However, different countries and industries had their separate set of rules, which created disjointed and fragmented revenue recognition standards. This made it challenging to fairly compare the performance of companies globally. To solve this problem, FASB and IASB created joint regulations called ASC 606 (in the US) and IFRS 15 (internationally), which set a new, shared framework for recognizing revenue across industries and business models.

Requirements for Revenue Recognition Model

The joint standards outlined in ASC 606 and IFRS 15 require that companies adhere to a five-step revenue recognition model.

  • Identify the contract with the customer

Set credit terms for your customer. When you make a contract with a customer, prepare the invoice that mentions the service, charges and credit terms. Credit terms indicate the number of days the customer has to pay that invoice. A customer agreeing to those credit terms is obliged to pay within the stated number of days. A contract can be a formal written agreement, as is often the case with service-based businesses, or a receipt for a point-of-sale purchase at a retail store. 

  • Identify the contract’s specific performance obligations

There should always be clarity and transparency regarding your performance obligations to the customer. The term “performance obligation” refers to a “distinct” product or service that the seller has agreed to deliver.

  • Determine the transaction price

The exact transaction price for the product or service needs to be finalized and presented to the client before recognizing revenue. Along with the direct charges, the right to return and potential discounts also come under transaction price. 

  • Allocate the transaction price to distinct performance obligations

Assign a price to each performance obligation in the contract. Base the prices on relative standalone selling prices like the sale of similar goods or services, a contractually stated price, or a list price.

  • Recognize revenue when you’ve fulfilled each performance obligation

Revenue is only recognized when you have completed your part of the agreement. When the product is delivered or service is provided, only then does the amount of set payment can be added in your recorded revenue. Even if the payment is received in advance, it would not make it to revenue recognized until the product or service is delivered. 

Types of Revenue Recognition 

There can be different types of revenue recognition techniques depending on your business model. 

  1. SaaS and Digital Subscription:

For SaaS and digital subscription businesses where a customer signs up for a service or product for a specific period of time. Such businesses recognize revenue linearly across the service period.

  1. Subscription Models:

For subscription models that provide a product or service once every month, the performance obligation is the completion of the deliverable. 

  1. E-commerce Businesses:

In eCommerce businesses that receive payment before shipping the product, the revenue is recognized when the product is shipped as per ASC 606 and IFRS 15 standards. 

  1. Instalments:

Companies operating on payments in instalments recognize revenue when the product is delivered while the payment slowly keeps adding to the received revenue. 

  1. Pre-paid metered billing:

In metered billing, customers pay the amount they use. Pre-paid metered billing records revenue in bits as the customer uses the facility.

  1. Post-Paid Metered Billing:

In post-paid metered billing, revenue is recognized when the invoice is sent at the end of the set time duration. 

  1. Digital Goods:

For digital assets that can be downloaded when bought, revenue is recognized once the customer downloads the digital good. 

How can Metric help? 

As your business grows, managing revenue recognition with accuracy, efficiency and transparency becomes more and more difficult. Manually carrying out these technical accounting tasks decreases creativity, increases frustration thus creating a higher risk of human error. 

Metric saves you from the trouble by organizing all your finances in one place. It lets you access and assess your revenue, automates repots, provides a real-time dashboard, gives business insights specific to your company, audits in real-time, and lets you keep a record of your receipts. Once all these processes are automated, and data organized, you can look into your revenue recognized in a glance. 

Beyond being necessary for a company’s immediate financial health, Metric provides important strategic tools for entrepreneurs. It empowers small business founders to make accurate future predictions in real time. This leads to smart budgeting in the present and strict adherence to that budget, avoiding the potential pitfalls.