You have a lot going on when operating a small business—and handling your bookkeeping generally isn't the sexiest on the list. Why should you be concerned with mastering even the most basic accounting principles when you have sales to close, a website to market, and customers to please?!Having an understanding of basic accounting principles—or at least the big ones like the revenue recognition process and why it's important—will ensure you don't jeopardize your business. Although the future of accounting appears to include a lot of machine learning and automation, some of the fundamentals should still be something you aim to understand.
What Is The Revenue Recognition Process?
Before we discuss its value, it's important to understand what the revenue recognition criteria include. According to the Financial Accounting Standards Board, the revenue recognition standard states that revenue should be recorded when the revenue-generating process has been completed, or when it has been earned, rather than when the payment of revenue is actually received. In other words, the payment terms must be clearly stated and understood in the contract and both parties must approve and commit to it before it is considered identified. So if you're in an industry that collects payment upfront for a service, for example (i.e., SaaS, development, software, home services, etc.)—you'll want to read on.
When Should You Use the Revenue Recognition Principle?
Here's an Example:
A landscaping company completes a one-time landscaping job for their normal fee of $200. The landscaper can recognize revenue immediately upon completion of the job, even if they don’t expect payment from that customer for a few weeks. But things change slightly when the same landscaper is offered $2,000 upfront to maintain all the landscaping over a three-month period. In this case, the revenue recognition standard requires the landscaper to recognize a portion of the advance payment in each of the three months covered by the agreed-upon payment terms (to reflect the pace at which it is earning the payment). However, if the landscaper doubts that any payment will be received, or they suspect a major risk, then they should not recognize any revenue until receiving the payment in full.
Also under the accrual basis of accounting, if the landscaper receives their payment in advance from a client, then the payment should be recorded as a liability - or deferred revenue, not as accrued revenue. Only after the landscaper has completed all the work under the contract with the customer can they recognize the payment as revenue. Under the cash basis of accounting, you should record revenue when a cash payment has been received. For example, using the same scenario from above, the landscaper will not recognize any revenue until it has received payment from their client, even though it may be weeks after the landscaper completes all of the work.
If services are performed entirely and/or the job is completed, you should know when revenue is recognized. If the job is not completed or fulfilled in entirety according to an agreed-upon contract (a performance obligation), recognize the revenue over the entire period, as it is earned.
The most important reason to follow the revenue recognition standard is that it ensures that your books show what your profit and loss margin is like in real-time. It's important to maintain credibility for your finances. Financial reporting helps keep your transactions aligned.
Consider the same landscaping business from the example above. The company frequently spends large amounts of money on supplies, plants, machinery, etc., to prepare for seasonal fluctuations and trends. If the landscaper could not record the revenue until all client payments were actually transferred and cleared the bank, it could cause their books to appear to be deep in the red for a long period of time. That's no way to run a business!
By leveraging the revenue recognition principle, the company maintains a steady balance of cash going out, and revenue coming in. This is a more accurate picture of the company’s financial health. One major reason the revenue recognition standard can be so important is that the financial health of the company can greatly affect its ability to attract investors. When revenue appears to be fluctuating wildly, stockholders typically don’t want to stick around, but by presenting an honest picture of a stable financial department, the company portrays a safer investment. This can be a serious consideration for small businesses that are trying to grow.
Advance Payments or Doubtful Accounts
One thing to note about the revenue recognition standard is that it does make allowances for payments that come early, late, or not at all. If a client pays you early (for example, if you require a deposit as part of your contract), then the revenue recognition principle states that you should record the revenue as a liability. After you complete the work and the contract is satisfied, you can change the recording from liability to revenue.
Here's another variation on this example: if you're paid a lump sum to cover a short-term contract, you should record each month’s worth of pay as a separate amount so that your books show the pace at which you're earning the revenue.
For example, if your transaction price is $1,000 per month for your services, and you are hired for a three-month contract, your client may choose to pay you the full $3,000 upfront. You should still only record $1,000 each month as revenue. For accounts where you somewhat suspect the client may pay late or not at all, the revenue recognition standard only suggests that you note this doubt and adjust accordingly when the payment arrives. However, if you seriously suspect that the payment will not come, the principle suggests that you do not record the revenue at all unless it arrives.
Pairing Revenue and Expense
The International Financial Reporting Standards (IFRS) sets the rules for accounting by determining how transactions are recorded in financial statements. The revenue recognition principle has another very important purpose, which is to ensure that the cause-and-effect relationship of expenses and revenue is very clear. By showing revenue when it is earned and connected to the expense that was necessary to earn the revenue, you as a small business owner can much more easily see how profitable certain lines of your business are.
You may not have previously realized how expensive it was for you to earn your monthly fee from a specific client. This accounting principle can help you trim the fat for a more efficient business. Matching your revenue and your expenses by using the revenue recognition principle is sometimes also called the matching principle or expense recognition principle, which falls under the same “family” of accounting as the revenue recognition principle (part of the accrual accounting method).
That means that when revenue is recognized, according to the matching principle, expenses must also be reasonably measured.
While the revenue recognition principle can be useful for many reasons, it’s important to separate recognized payments from your understanding of “spendable money.” Learning how important the revenue recognition standard is will become more obvious once you start to seeing it as a measure of success. Your financial health will be positively impacted, and you'll begin to see it in your financial statements!
Occasionally, the Financial Accounting Standards Board updates these principles to reflect new needs in accounting as the business evolves, so it’s also important to keep up with the most recent standards. This principle was last updated in May 2014, when the FASB clarified how to recognize revenue and worked to establish a general standard for revenue accounting with the International Accounting Standards Board (IASB). With many of the past’s inconsistencies now gone, it’s much easier to record revenue and work with your accountant to measure your company’s success. Leveraging a high-quality bookkeeping solution can help you get things in order quickly with this new revenue recognition model!
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Editor's note: This post was originally published in July 2017 and has since been updated for accuracy and clarity.