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WHAT IS THE REVENUE RECOGNITION PRINCIPLE?

Updated: Oct 10, 2023

For any senior leadership members who don’t directly carry out their own accounting functions, the revenue recognition principle (often abbreviated to rev rec) may appear not to overlap with their duties. However, revenue recognition and the principles surrounding it have some major effects on the viability of companies in the short and long-term, as well as how well they manage crucial parts of the business such as sales, expense management, and more.


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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 often recognized when a critical event occurs, such as the product being delivered to a customer, and the dollar amount can be measured easily by the organization.


WHAT IS THE REVENUE RECOGNITION PRINCIPLE?


In essence, the revenue recognition principle means that companies can only record revenue once it has been earned, and not when the cash has been received. When a company makes a sale, the revenue they have earned would have to be recorded so that it can be correctly reflected on the income statement. The question this poses is when is the right time to recognize this revenue?


The revenue recognition principle is a crucial part of the accrual basis of accounting, and it is a major part of the Generally Accepted Accounting Principles (GAAP). The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have recently developed a new set of guidelines surrounding revenue recognition with the aim of reducing inconsistencies throughout all industries, and to provide a better framework to help businesses tackle accrual accounting more effectively. The process of completing revenue recognition is laid out in five steps, which are as follows:


  1. Enter into a contract with a customer

  2. Agree on the company obligations defined in the contract

  3. Come to an agreement on the transaction price

  4. Determine a price to the obligations

  5. Satisfy the contract’s outlined obligations and record the revenue correctly


It’s worth noting that in the above criteria, there is no mention of receiving payment for the service provided. This is because the accrual basis of accounting is not connected to the cash basis of accounting, which states that revenue is only recognized when a cash payment is received.


HOW REVENUE RECOGNITION AFFECTS EVERY PART OF A COMPANY


Often, employees who are not directly involved with the accounting functions of their business pay little to no attention to said functions. Sales managers for example focus most of their efforts on getting the important “yes” from a prospective customer, but rarely delve further into matters after that. How the revenue from every sale is recognized is extremely important, not only to the sales team, but every stakeholder in the organization.


The revenue recognition principle has a ripple effect that involves every aspect of a business. If revenue is recognized accurately and on time, the subsequent income statement paints an authentic picture of the company’s financial health at that point in time. If a company recognizes too much or too little revenue during a specified accounting period, it could have a big impact on how different departments are budgeted. If they record too much revenue, a department may overspend because they think they have more money to utilize than they actually do, which could cause major cash flow issues for the company as a whole. At the other end of the spectrum, if a company receives more cash than anticipated because of under-recognized revenue, the risk here is missing out on further resources that could otherwise be used to encourage increased growth.

This can have a major impact across all departments of a business, causing ramifications when it comes to how every team works on a daily basis. Lines can become blurred in sales for example, as determining when revenue is recognized can lead to question marks over when the sales team can receive their commission. Development teams may also share their confusion if they see a lucrative sale has been made, but no money has yet been allocated to their next project because the revenue is not yet seen as cash. The solution to this issue is clear and constant communication throughout the entire company, so teams know when they can reap the benefits of any incoming cash into the business that will be earmarked for them.


One of the key considerations when evaluating the financial health of a company is total revenue. When analysts assess a company’s revenue, they make valuations, which are based on total revenue. These assessments will have a wide array of effects, impacting all four corners of an organization, including borrowing ability, stock price, and its acquisition potential.

 

WHAT NEXT?


Now that’s covered, revenue recognition and its principles should now be less alien to you, and you can take this and use it as the basis for planning your revenue recognition strategy. The added requirements can be a lot to take in, which is why revenue recognition software can do a lot of the heavy lifting. Revenue recognition is the talk of the industry, which is why we’ve got lots of resources to help guide you through it. Take a look at our blog today to learn more about revenue recognition as well as other topics of interest affecting the SaaS world.


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