Imagine, as a SaaS company or IT consultancy, that you’ve just brought in the most lucrative customer in your history, promising tens of thousands of dollars in lifetime value from just one sale.
Once the cash is in your account, the first thing you’ll want to do is update the accounts to express this injection of revenue. You need to think twice before doing so, however. Even with cash in the bank, this isn’t revenue, and it can’t be counted as such until it’s earned. Seeing cash and revenue as one and the same is dangerous for SaaS businesses, and firms in any other industry.
So when do you record your revenue?
To assist you with this issue, we’ve compiled some examples that highlight revenue recognition and show how it should be realized for a number of different business types.
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WHAT IS REVENUE RECOGNITION?
Revenue recognition is an accounting principle that outlines the conditions under which a business can record a sale as revenue or cash that is earned. Only at that point can it then be ‘recognized’. Revenue is typically recognized when a critical event occurs, a significant one being when the product is delivered to a customer, and the dollar amount can be measured easily by the organization.
REVENUE RECOGNITION EXAMPLES
The simplest way to explain when you should be recognizing revenue in your own business is by seeing it up close. With that in mind, let’s look at a few revenue recognition examples featuring fictional organizations.
Beginning with an organization in the world of retail, Company A sells primarily kitchen appliances, but they lack showroom space, meaning customers usually purchase fridges, washing machines, and other large items without being able to take home the products on the same day. Instead, delivery and installation is scheduled to be completed further down the line.
In one scenario, we’ll say that Company A sells an appliance package to a customer on January 1st for $5,000, the customer pays on February 1st, but the appliances aren’t delivered until March 1st. Company A should recognize their revenue when the products are delivered to the customer, even if it is paid for in the previous weeks or months. In the example we’ve described, the revenue should be recorded in March because that’s when the items were delivered to the customer, despite the sale being booked in January and paid for in February,
Company B is a software company that creates and sells a CRM package for enterprise customers. Instead of running a SaaS product, the organization delivers its software in a more traditional way, with a one-time software package, which is run by and installed on local hardware of the customer.
If Company B releases a new version of the software in December, which costs $15,000 upfront, when a customer purchases and receives this software in December, the company can record the sale and recognize all of the $15,000 worth of revenue in the same month.
This is a great example of revenue recognition because it is so simple. Because the customer acquires the software immediately and uses it on their internal hardware, Company B can recognize the revenue immediately. Grocery stores and many other retailers work in a similar way - Once customers have bought their groceries and they have been delivered, revenue is recognized.
As simple as this example is, however, it’s worth mentioning the importance of knowing the difference between cash and revenue. We will discuss this further in the next example.
Company C is also a provider of CRM software and they develop a SaaS product. They differ from Company B however because they don’t include a one-time charge, and instead charge a yearly subscription fee of $15,000 for customers to access their service, with many customers paying the yearly fee in advance instead of a monthly payment.
The major difference with this payment method compared to traditional software is that Company C still have to earn their revenue, despite the customer already paying for the whole year up front. What spans the whole year though is the delivery of the service, which means revenue recognition takes place monthly and the rest is deferred revenue. This would not be ideal if Company C were looking to improve their cash flow.
An issue with SaaS is that this subscription model of doing business is not helped by GAAP. There are no specific revenue recognition standards for SaaS businesses, and this often creates a hurdle for many SaaS businesses. With no accounting standards, some SaaS organizations fail to understand that they must recognize the revenue for a service bit-by-bit throughout the full time period of that service. If Company C recognized all of the revenue straightaway and benign spending the cash, they won’t have much of a leg to stand on if a customer comes to them asking for their money back.
Service providers (IT Consulting)
The fourth and final example we have comes from the world of IT consulting. Company D provides IT solutions to scaling startups.
If Company D delivers $10,000 worth of IT services to a customer in January, but the customer doesn’t pay for said services until May, then the company could still recognize their revenue in January. This is the case for much of the service-based work landscape, where revenue recognition for services like consulting actually happens at the time of consulting despite a customer potentially paying at a later date. This is why Company D should recognize their client revenue in January, even though the cash for this consulting service wasn’t received until May.
Revenue recognition is not just for compliance, but it serves an important purpose in enabling companies to maintain revenue recognition accuracy with standards and regulations. You’ve seen just a snapshot of the many different use cases for revenue recognition in a variety of businesses and industries, and all companies that keep on top of it can begin to understand how they are performing compared to their initial targets, as well as competitors.
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