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Revenue recognition is a key accounting principle in which a company records its revenue as it earns it, not necessarily when paid for. Critical milestones mark when revenue can be recognized, like when the business delivers the product to a customer. It is a facet of accrual accounting, where revenue is recognized when the obligation to the customer is complete.
This contrasts with cash accounting, where revenue is recorded upon payment receipt. This practice is important because it ensures transparency and consistency in how companies report their earnings, helping them provide accurate financial information to stakeholders, shareholders, and regulatory authorities.
What is the history of revenue recognition?
Historically, industry type dictated international accounting policies. This led to confusing and disjointed revenue recognition standards, making comparing performance for companies in different industries harder.
In 2014, the Financial Accounting Standards Board (FASB) partnered with the International Accounting Standards Board (IASB) to develop a joint regulation. This shared regulation is known as ACS 606 in the US or IFRS 15 internationally. It provides a common framework for revenue recognition that is both industry- and business model-agnostic. Publicly traded, private, and nonprofit organizations can use this five-step model.
What are the different types of revenue recognition?
Revenue recognition methods vary based on the business model. Digital subscription models recognize revenue differently than digital goods, for example. Here are a few common types:
- Digital subscriptions (including SaaS) – Customers may sign up for digital subscriptions for a set period, with value delivered throughout that service period. In many cases, revenue is recognized linearly across the service period. However, a company must also account for upgrades, cancellations, prorations, and downgrades.
- Ecommerce with future fulfillment – Customers usually pay before they receive the goods when making an ecommerce purchase. Revenue recognition will depend on the company’s contractual relationship with customers; however, ASC 606 recommends recognizing revenue at the point the product is shipped.
- Digital goods – Unlike ecommerce with future fulfillment, companies can fulfill digital goods (like ebooks, movies, and music) in real time. Companies can recognize the revenue of these downloadable assets the moment the customer downloads them.
What’s an example of revenue recognition?
Let’s say a personal styling service charges $100 per month to send a curated box of clothing each month to subscribers. The fee for the tailored clothing is charged at the end of the month prior to the month the customer receives the box. There is also a one-time fee of $50 to learn more about each customer’s fashion style, sizing, and other preferences through an online questionnaire.
Once the styling service has received the completed questionnaire and created a curated fashion plan for the customer, it can recognize the $50 fee.
While the customer may pay for February’s fashion box on January 29th, the company cannot recognize the $100 recurring payment when it is received because it has not been earned. Instead, the revenue will be marked “deferred” until the end of February after the company delivers the box to the customer. Then, it can update the ledger to show newly recognized revenue.
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Explore the fundamentals behind back office finance processes and the accounting principles underlying them.
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