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REVENUE RECOGNITION METHODS

Updated: Oct 3, 2023

In business, revenue is what makes the world go round.


It is one of the most crucial components in a financial statement because it measures the profitability of a SaaS business’ services. Preparing your company’s financial documents can be a very daunting task, so it’s crucial to understand the importance of sales revenue on an income statement so you can accurately report and forecast. In order for your business to actually consider revenue as earned, it needs to be tracked to a correct standard, or to use the more common term, ‘recognized’.


Recognizing your revenue with precision is crucial to your company’s financial performance; once you know the exact financial position of your business, you can manage operations much more efficiently and make necessary investments.


So with that in mind, discover our top methods for recognizing revenue based on your business and its requirements in our detailed guide.


Ready to learn more? In this guide, we’ll look at:



WHAT IS REVENUE RECOGNITION?


Revenue recognition is an accounting principle that identifies the specific conditions under which a business can record a sale transaction as revenue/cash earned; only then can it then be ‘recognized’. Revenue is typically recognized when a critical event occurs, such as the product being delivered to a customer, and the dollar amount is measured easily by the company.


For example, in SaaS, most companies use a subscription business model, which means that they don’t receive revenue until the service has been actually delivered to the customer (earned). Any prepayment made by a customer before this is a liability because they may cancel their subscription and ask for a refund. This is why a SaaS business cannot treat a subscription payment as money until it earns revenue.


The revenue recognition standard in the U.S, ASC 606, provides businesses with a uniform framework for recognizing revenue from contracts with customers. Read more on that here.


WHAT ARE THE DIFFERENT TYPES OF REVENUE RECOGNITION?


Every business will offer slightly different services, with slightly different ways to pay for them. Some companies offer packages, bundles, and even a pay-as-you-go model that can put a strain on recognizing revenue.


Below are the top methods for recognizing revenue in your organization.


Sales-based method


With the sales-based method of revenue recognition, you can recognize any revenue as soon as a sale is made. If a customer walks into your store and purchases an item for example, you can recognize that revenue instantly.


Whether a customer is paying with cash, on credit, or even just has a very high likelihood of paying, you can use this method of revenue recognition. The sales-based method is not dependent on payment, and it is instead the delivery of the service that triggers the revenue recognition event.


This method is commonplace in retail as delivery is clear and immediate, despite the payment not always being paid straight away.


Installment method


The installment method is normally used for larger purchases, such as real estate, large machinery, and any other items where the reliability of customer payments is not 100% guaranteed. If a company is not sure about receiving payment, the installment method allows them to recognize revenue, as a percentage of total revenue, only when payments are received. This can be over months or even years and can quite often be unexpected.


Percentage of completion method


The percentage of completion method is often used with long-term contract agreements, and it allows organizations to recognize revenue based on milestones and other useful progress indicators. This revenue recognition method requires a contract that clearly outlines each deliverable so every part knows when revenue recognition may take place.


The percentage of completion method enables businesses to recognize revenue in real-time, and eliminates the need of waiting until the end of a long contract. Financial statements show a much more consistent stream of revenue, which is far more predictable as there are fewer large spikes.


Completed-Contract method


The completed-contract method enables you to recognize revenue when the entirety of a contract is fulfilled and all performance obligations have been met. This is an ideal method for businesses to employ over shorter contract periods so they can be sure revenue appears on financials in the correct period. The completed-contract method is not for you if you are offering extended warranty periods or a long-term return policy.


This method of revenue recognition often becomes the default for many companies that cannot recognize revenue on the Percentage of completion method shown above because there isn’t enough clarity around performance obligations or when the contract is enforceable or not.

Cost Recoverability method


The cost recoverability method is another choice when you are unable to estimate the likelihood of collection. The installment method should be used when you know the related costs, and the cost recoverability method when you either don’t know or cannot estimate the cost of goods or services needed to honor the contract.


This is by far the most conservative method of revenue recognition, as you can only do so after all costs associated with the contract have been recouped fully. There is no guarantee of when this will be, and it could even be some time after the contract has been completed and all performance obligations have been satisfied.

SO, WHICH METHOD SHOULD YOU CHOOSE?


Every revenue recognition method discussed here has its advantages and disadvantages and each has its own use case. If you’re scratching your head, wondering which method to pick, you must first look at your business model and how you sell your services. Many of the above methods depend on the length of contracts, so this could be a good starting point. If you work more with shorter contracts, it may be worthwhile to look at the completed contract method, but if it’s longer term contracts you favor, the percentage of completion method may be the way to go.


Take a look below at the advantages and disadvantages of each revenue recognition method:

REVENUE RECOGNITION METHOD

ADVANTAGES

DISADVANTAGES

Sales-based

  • Accurate cash flow

  • Single-entry system makes it easy to use without complex accounting system

  • Single-entry system increases risk of errors

  • Works well for short-term data but makes it more difficult to see full overview of your business

Installment

  • Sales generated from customers who otherwise wouldn’t be able to buy from you at all

  • Reduces cash flow problems

  • Increases the profitability if customers return for further business

  • Additional time is needed to track payments and chase them up

  • There is a risk customers may miss payments or not pay the outstanding ones

  • Anticipated income over a specific period of time can be less if payments aren’t made on time by customers

Percentage of completion

  • Increased cash flow due to incoming income at different intervals for each project

  • Reduced risk of non-paying customers, eliminating a significant loss of income

  • Offers real-time estimation for business revenue and cost on each project

  • This is a time-consuming method because you must be up to speed with every project. Must decide whether to continue to next project phase or not

  • If estimated costs need to be adjusted for the payment this requires keen attention to detail

Completed-contract

  • This method can encourage tax efficiencies from the delayed reporting of revenue and expenses

  • If projects are completed ahead of the original schedule, the projected profits can increase due to the reduced time needed to complete it and earn the same amount

  • A thorough, dedicated balance sheet must be maintained for each project to record all its revenue and expenses. This is a very time-consuming process

  • This method can lead to cash flow problems for an organization with too many projects not yet paid for

  • If a project requires further time, there will be no additional earnings for it and the overall profit would be reduced

Cost recoverability

  • A dependable method when it comes to projects that have less of a guarantee of recovery of the money from the customer

  • Tax only needs to be paid once the entire cost of the service is recovered

  • With this method, there is a potential delay in the recognizing the gross profit

  • The period in which the sale is made and the period when the profit is actually recorded can differ


It’s important to get this right, as choosing the wrong method for your business can lead to inflated or deflated revenue, expense and profit numbers. Inaccuracy with these numbers can lead to poor management decisions and low investor confidence. With this in mind it’s crucial that you pick the method which best reflects your reality in your financial statements.


HOW PRECURSIVE CAN HELP WITH REVENUE RECOGNITION


Whichever revenue recognition method you decide is best for your business, solutions like Precursive can help you to forecast and recognize revenue aligned to your business model. Precursive can automatically calculate revenue forecasts so you can see where you are at any given time.

Precursive Revenue Dashboard
Precursive Revenue Dashboard

Precursive’s revenue recognition software allows you to:

  • Customize revenue recognition tracking to your business needs

  • Recognize revenue based on project tasks, timesheets or milestone completion

  • Import or export revenue transactions into your financial system

  • Forecast and recognize revenue on both fixed price and T&M projects

 

WHAT NEXT?


Revenue recognition and its methods are not just for compliance. It serves a very important purpose in allowing organizations to maintain revenue recognition accuracy with standards and regulations. Keeping on top of it means you can very quickly understand how you are performing compared to your competitors, and it’s almost impossible to put a price on that.


Want to learn more about how Precursive can help? Book a demo today.








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