Revenue Recognition Methods: A Comprehensive Guide.

How many nights have you sat sleepless in front of your spreadsheets and reports? Just trying to make sense of where these numbers came from! What are these gaps? 

How many days have you spent scratching your head confused over long statements? 

Well, revenue recognition is that part of business operation that leaves most people baffled. 

So here is a blog, answering all your questions and doubts. A comprehensive guide to everything you need to know about revenue recognition. 

In this article, we will explore the meaning of revenue recognition, its importance, and the different methods. 

We will take you through the factors to consider while choosing your suitable method. Give you a detailed analysis and comparison of each method. 

We will walk you through the five steps and four principles of revenue recognition. We will explain the challenges and suggest solutions to overcome them. 

Then we end by discussing the accounting standards. 

Excited about the comprehensive reading on revenue recognition methods? Let's scroll down for more.  

What is Revenue Recognition?

Revenue recognition is an accounting principle to keep track of the money a company has made by selling its products or services. 

Revenue can be recognized only when you have earned your money or when you have made the delivery to the customer and there is the assurance of payment.  

Revenue recognition helps companies accurately assess their financial performance and positioning.

It also helps investors, banks, and other institutions to understand the financial health and success of your business. 

Why Revenue Recognition Matters

Revenue recognition matters in business. It is of importance in various business operations from financial reporting to analyzing your financial performance. 

Following proper revenue recognition helps companies understand their financial performance accurately. 

This in turn helps investors, banks, creditors and other stakeholders make informed decisions about the company. It also helps in assessing their creditworthiness when extending loans of credit. 

When companies follow proper revenue recognition practices it enhances their transparency and comparability. Stakeholders can compare and check your company’s performance with your competitors.  

Revenue recognition gives a clear picture of the company’s financial landscape and helps assess its ability to generate future cash flows. Investors feel confident when companies follow proper and transparent revenue recognition practices. 

Following revenue recognition is essential for legal and regulatory compliance. It is compulsory that businesses follow accounting standards like GAAP or IFRS set by governing bodies. 

In addition, regular reporting of revenue helps reduce financial misstatement, fraud, regulatory penalties, and even reputation damage.  

All these cases show how revenue recognition helps maintain the company’s integrity, ensure stakeholder trust, adhere to financial regulations, and mitigate risks. 

Following these steps and measures thus helps in economic stability and consistent growth. 

Different Revenue Recognition Methods

Revenue recognition methods differ based on the nature of the business, the type of transactions, applicable accounting standards, etc. 

Based on these differences, the different types of  revenue recognition methods include: 

• Sales-basis method
• Completed-Contract method
• Installment method
• Cost-recoverability method
• Percentage of completion method

We will discuss these methods in detail in the following section of this blog. 

What factors to Consider When Choosing a Method

Choosing the right revenue recognition method is a subjective process. Your business model, industry practices, and regulatory requirements are a few factors to name. 

Let us look at what are the other factors that influence your choice of method: 

Nature of Goods or Services

The primary factor for choosing your revenue recognition method is the product or service you provide. Is it a one-time delivery product or a subscription-based service? 

Industry Practices

The industry you belong to might have commonly accepted revenue recognition practices. Following these industry standards and best practices helps in recognition compliance. 

Contractual Terms

Customer contract terms include performance obligations, payment terms, and other relevant information. These terms can influence the timing and amount of revenue recognition. 

Regulatory Requirements

Businesses must ensure compliance with relevant standards to avoid any regulatory risk or penalties. Some of these accounting standards include GAAP or IFRS. 

Costs of Implementation

Businesses must consider the cost of implementing different revenue recognition methods. This includes software systems, training, compliance efforts, etc. 

Stakeholder Preferences

Your investors, creditors, and analysts might have their preferred recognition method. Choose the method that provides stakeholders transparency and clarity. 

Future Growth and Scalability

Evaluate if the chosen method can accommodate future changes in business models and market expansion. The method must be flexible and adaptable to these changing requirements. 

Companies must carefully assess these factors to choose a revenue recognition method that meets all their financial and regulatory requirements.

Comparison of Different Methods

By now we are aware that various factors affect your choice of revenue recognition method. 

But that doesn’t make your choice easy. 

Each method has its unique features that make it suitable for different goods/services and industries. 

So here is a comparison between revenue recognition methods to help you make the right choice. 

Detailed Analysis of Revenue Recognition Methods

A mere comparison might fail to provide you a full picture of these revenue recognition methods. 

Your choice is dependent on your business model, product, contract terms, and other regulatory factors. 

So here is a detailed analysis of various methods of revenue recognition to help you choose the one that best suits your requirements: 

Sales-basis method

The sales-basis method recognizes revenue only when the cash is received from the customer. It is also known as cash method or cash basis accounting. 

It is a simple and straightforward method that focuses only on the payment time regardless of when the product was delivered. Hence, it's suitable for small businesses. 

Advantages:

• Sales-basis method is a simple and straightforward revenue recognition method. 
• Revenue recognition is directly tied to cash recipients or actual cash flow. 
• It reduces complexity in accounting as money is recognized only when received. 

Disadvantages:

• Since there is a mismatch between product delivery and payment, it can create confusion in assessing financial performance. 
• It does not account for the receivable or payable accounts which may not reflect the company’s financial position accurately. 
• It is not a useful method for businesses with complex revenue streams or long-term contracts. 

Example:

In January, your store sold $1,000 worth of clothes, but customers paid only $800 in cash during the same month. With the sales-basis method, you only count the money actually received as revenue. So, even though you made $1,000 in sales, you recognize only the $800 received in cash.

The method makes the accounting simpler, but it doesn't show the true financial picture. 

Completed-Contract method.

As the name suggests the completed contract method recognizes revenue only when all the terms under the contract are completed. It is primarily used in the construction industry. 

This means when the project is complete and all the obligations under the contract are fulfilled, the revenue is recognized in the financial statement. 

Advantages

• Completed-contract method is a straightforward and easy-to-apply method. 
• The financial statement is accurate since all revenue and expenses are recognized only when the project is completed. 
• It reduces risk. The completed contract method does not recognize any unfinished work.  

Disadvantages

• Since it delays revenue recognition, the method does not accurately reflect the company’s financial performance during the project. 
• The completed contract method causes profit smoothing. It does not consider significant fluctuations caused when expenses are made in one period and profits earned in another.  
• There is no timely information about the company’s financial performance during the project. This is because no expense is recognized unless the project is completed. 

Example:

A construction project will take two years to complete. In the first year, no revenue or expense is recognized. In the second year when the project is completed, the company recognizes its entire revenue and expenses. 

This simplifies the revenue recognition process and accurately reflects the revenue and expenses associated with the project. However, there is no proper tracking of the financial performance of the company during the project. 

Installment method

Installment method of revenue recognition is used when the price of a product is paid in installments. The total amount is divided into smaller amounts to be paid at regular intervals spread across a period. 

Here the revenue is recognized not at the time of sale but is recognized each time a payment is received. 

Advantages:

• The installment method improves the company's cash flow and aligns the revenue recognition with the actual cash flow. 
• Companies can reduce the risk of non-payment as it is paid in installments and only then will the product be delivered. 
• The installment method is simple and easy to apply making it suitable for car dealerships and appliance retailers  

Disadvantages

• Since customers have the choice to pay the amount in installments, there can be payment delays. This can negatively affect the company’s cash flow and revenue recognition process. 
• Keeping track of the installment payment schedule and the actual payment can become an administrative burden for the company. 
• Delays in payment mean delays in revenue recognition. This can affect the accurate reflection of the financial performance. 

Example:

A company sold machinery for $100,000 under an installment contract. The customer has to pay an amount of $20,000 for the next four years.  

Under the installment method, the company will recognize the revenue of $20,000 each year for the next four years upon receiving the amount. 

Cost-recoverability method

The cost-recoverability method does not recognize revenue unless the cost incurred on a project is received. It is also known as the cost-recovery method. 

This method is used when companies are uncertain whether the total cost of the project will be recovered through future revenue. 

Advantages:

• Since revenue is recognized only after receiving the incurred cost, it reduces the risk of overestimation of profit. 
• This method of revenue recognition example provides a clearer picture of the company’s financial position. 
• Recognition is deferred until the incurred cost is received. This reduces the risk of recognizing revenue that may not be paid.   

Disadvantages:

• The cost-recoverability method defers revenue recognition until the cost is recovered. This can affect the accuracy of the company's financial performance. 
• It has limited use. This method is suitable only in scenarios with uncertainty in revenue collectability.  
• Negatively impact the financial statements and KPIs due to delayed revenue recognitions. 

Example:

A software company developed a product that incurred a cost of $100,000. However, they are uncertain about its future sales and revenue generation. Hence, they defer revenue recognition until they collect the $100,000 by selling the software. 

Once they have generated the incurred cost from software development, they begin their revenue recognition process. 

Percentage of completion method

Percentage of completion method recognizes revenue and expenses based on the percentage of completion achieved. This means the revenue and expense recognition process begins after estimating the percentage of work completed.  

This method is commonly used in long-term construction and manufacturing projects. 

Advantages:

• Revenue is recognized as the project progresses. This provides a more accurate picture of the financial performance. 
• It follows the matching principle of accounting. Under this principle revenue recognition is aligned with the incurred expense during the project. 
• As revenue and expenses are recognized throughout the project, stakeholders have more timely and reliable information on the company's performance. 

Disadvantages:

• Accurate estimation of the percentage of completion of long-term projects can be tricky. This can in turn create confusion in how much revenue to be recognized. 
• Changes in the estimation of project completion or cost will impact revenue recognition. This can further cause mishaps in your financial statements and reported earnings. 
• The revenue is recognized based on a percentage of completion. The timing difference between revenue recognition and cash flow can affect the company’s liquidity position.  

Example:

A construction company is building a house for a client. The total contract value is $1,000,000, and the project is expected to take two years to complete.

At the end of the first year, the builders estimated they completed 30% of the project based on the costs incurred and the progress made. Based on the estimation, the builders would recognize revenue for the first year as $300,000. 

They would continue to recognize revenue each year based on the percentage of completion until the project is completed. 

We saw that the business model, product/service, industry, mode of payment, and time of payment play a major role in determining your revenue recognition model.

So which revenue recognition method best suits your business and industry? 

For further reading, check Deferred Commissions: ASC 606 Impact on Sales Accounting

What are the 5 steps in the revenue recognition process?

The International Financial Reporting Standards and Generally Accepted Accounting Principles have outlined a five-step process for revenue recognition. 

Companies must follow these compulsory steps to comply with the regulations. 

So what is this steadfast path in revenue recognition? Let's explore. 

Identify the Contract with the Customer

The first step in revenue recognition is identifying the contract. This means determining a contract between the company and the customer, making sure both parties agree to the terms, and making it enforceable. 

This contract can be written, spoken, or implied based on the business.  

Identify the Performance Obligations in the Contract

The performance obligation is what you promise to deliver to the customer. Companies must ensure that the different goods you deliver must be of benefit to the customer.  

Determine the Transaction Price

In this step, you figure out how much money you make out of selling your goods. Companies have a particular amount of money they expect out of the transaction. 

However, discounts and bonuses must be considered while assessing how much they are likely to earn from the sale. 

Allocate the Transaction Price to the Performance Obligations

If a contract offers multiple performance obligations, then it must mark how much each obligation is priced. This means the company must state clearly how much each good/service charges separately. 

This gives clarity and accuracy in revenue recognition. 

Recognize Revenue When the Performance Obligations are Satisfied

Revenue is recognized when you deliver the promised good or service to the customer. They have the control to choose how and when to use the delivered product. 

Depending upon the payment (one-time or recurring) method in the contract companies can recognize their revenue. 

IFRS and GAAP provide a structured framework for companies while recognizing their revenue. 

This helps ensure consistency and comparability in revenue recognition practices between different industries and business models. 

What are the 4 principles of revenue recognition?

The IFRS and GAAP have laid down four principles for revenue recognition. 

These key principles provide a foundation for when and how revenue recognition must be done in financial statements. 

Revenue is recognized when earned

Under the first principle, revenue is recognized when it is earned rather than when the payment is received. 

This means companies can recognize their revenue when they have transferred their goods, provided their service, or fulfilled the promises in the contract. 

Revenue is recognized when realizable  

Revenue must be recognized only when you are sure of getting the payment for your goods or services.

Following this principle ensures that your financial statements are accurate and reliable. 

Revenue is recognized based on the money the company expects to receive

Revenue must be recognized based on the expected amount the company will receive. 

This includes the fixed payments to be received as well as the other variable pays like tips or other offers. Including these extra details makes your financial report more accurate. 

Revenue is recognized when control of goods is transferred to the customer

Revenue must be recognized when the promised goods or services are delivered to the customer. This can be a one-time delivery or subscription-level usage. 

After the promises in the contract are fulfilled, the customer has the freedom to use the product or service as and how they like.  

Designing these principle guidelines helps companies determine when and how to recognize their revenue. This ensures accuracy and uniformity in determining the company's financial performance and position. 

Common Challenges and How to Overcome Them

What is AS 9 revenue recognition

Accounting Standard 9 (AS9) is a guideline that outlines principles for revenue recognition in financial statements. It was issued by the Institute of Chartered Accountants of India. 

It states that revenue must be recognized when it's earned, collected, or when there is surety in getting the payment. 

It has issued specific criteria on how revenue must be recognized for the sale of goods, rendering services, and other enterprise resources like interest, royalties & dividends. 

These guidelines help match revenue with related expenses and accurately reflect the company’s performance. 

AS9 provides a framework for companies to follow while preparing their financial statements. This ensures consistency and transparency in the revenue recognition practices. 

What is ASC 606?

In the US, the revenue recognition rules come under Accounting Standards Codification 606 (ASC 606) set by the Financial Accounting Standards Board. 

It provides industry-specific guidelines and comprehensive standards for revenue recognition across different industries. This brings uniformity and consistency in the revenue recognition practices. 

It provides a structured approach to revenue recognition by considering factors like contract terms, performance obligations, transaction prices, etc. 

ASC 606 helps stakeholders and investors get reliable and accurate information about your company’s revenue generation and financial performance. This gives transparency on your revenue flow and helps them make better-informed decisions. 

For further reading, check ASC 606: What Has Changed for Sales Comp Leaders?

Final Thought

Revenue recognition is a crucial part of your business operations. 

It provides clarity on your financial performance. It gives transparency to stakeholders about your financial landscape. It helps reduce risk and prevents misstatements. 

This is just the tip of the iceberg. The significance of revenue recognition trips down to all areas of your financial management. 

However, choosing the right revenue recognition method is a challenge. This requires considering your business model, understanding your product and industry, studying the standard procedure, and more. 

The rules set by institutions like IFRS and principles like GAAP provide standardization and clarity on revenue recognition practices. 

Eventually, it all falls on the company to make the final call. To ensure they comply with the rules and regulations and to keep their financial statements clear. 

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