Understanding Revenue Recognition Methods

Monitoring a company’s cash flow is a quick way to understand how well the business is doing. But there can be different metrics in revenue reporting. Accurately reporting revenue may get tricky as subscription businesses expand and customize their offerings. The amount of revenue that may be earned in a given period may not be the same as the amount billed or cash collected. 

Companies that report their earnings to stakeholders and investors often find that mere profit loss statements fail to accurately reflect the health of the business. While P&L statements merely indicate whether a business is profitable or not for a specific period, a comprehensive financial report shows the business’ growth potential and how its resources are being used against its liabilities. And that is why the revenue recognition principle is a cornerstone of financial reporting. 

In this blog, we’re going to discuss the importance and various methods of revenue recognition and the scenarios they’re typically used in.

There are structured rules around how businesses should calculate and report revenue. One such globally recognized revenue recognition standard is the ASC 606, issued by the International Accounting Standards Board (IASB) along with the Financial Accounting Standards Board (FASB). The ASC 606 defines a flexible, robust framework that proposes a 5 step model for revenue recognition. This model simplifies the preparation of financial statements for businesses by directing how much and when to recognize revenue. 

 

 

The Ultimate Guide for SaaS Revenue Recognition discusses what the ASC 606 framework means for SaaS companies and the key metrics that businesses must track.  

 

Why is Revenue Recognition Important?

Revenue recognition is crucial for businesses as it ensures accurate financial reporting, transparency, and compliance with accounting standards. Proper revenue recognition reflects the true financial performance of a company, providing stakeholders such as investors, creditors, and analysts with reliable information to make informed decisions. It also helps in assessing the company’s profitability, cash flow, and overall financial health. By recognizing revenue appropriately, businesses can avoid misrepresentation of their financial position and prevent potential legal and regulatory issues. Ultimately, adherence to revenue recognition principles fosters trust and confidence among stakeholders, contributing to the long-term sustainability and success of the business.

 

Common Revenue Recognition Methods

There are several methods through which income can be recognized as revenue in a company’s financial statement. The preferred method varies across industries and businesses. The ‘performance obligation’ defined in the ASC 606 framework is a distinct product or service promised to the customer. Understanding your business’s performance obligations and how they are satisfied is critical in choosing the right revenue recognition method.  

Here are some common revenue recognition methods.

Sales-Basis Method

The Sales-basis method recognizes revenue at the time of sale. If you walk into a grocery store and buy a cereal, that amount is recognized immediately. Naturally, this method is used by retail businesses because the delivery of goods is immediate, and the transaction is straightforward.  

It’s important to remember that the revenue recognition event hinges on the sale, i.e., the delivery of goods or services, even if the payment isn’t received right away. 

Percentage of Completion Method

This method comes into play when businesses work with large or long-term contracts. Companies need to show that they’re generating revenue even when the project isn’t completed. This is done by clearly delineating milestones or other indicators of progress in the contract, using which revenue is recognized over the course of the project.  

To use the percentage of completion method, you need to ensure that the contract you draw up is enforceable by law and that your service or offering has clearly quantifiable milestones.

The percentage of completion can be computed in two ways. Revenue can be recognized based on defined milestones or cost. For example, a software project could have the completion of a specific number of modules as a milestone. Revenue can also be recognized based on cost. If the total cost of a project is $20,000, it can be assumed that it’s 50% completed by the time they incur a cost of $10,000. 

Completed Contract Method

The completed-contract method allows revenue to be recognized only when the contract is completely fulfilled. It is typically used for short-term projects where it ensures that the revenue is recognized in the right accounting period. 

This is also used for long-term projects where the percentage of completion method cannot be applied because there aren’t any clearly defined indicators of progress. 

Cost Recovery Method

Possibly the most conservative approach to revenue recognition, the cost recovery method or the cost recoverability method recognizes revenue only after the costs of the service have been recovered. 

This method waits until the expenses of the contract are accounted for, instead of recording revenue and then offsetting those revenues with expenses. 

Once the costs have been recovered, the remaining revenue is recorded as income. This method is often employed in situations where payments are likely to be delayed. 

Installment Method    

The installment method works best for businesses that allow their consumers to pay for an item over multiple months or years. When someone buys a phone for $1000 and pays an installment of $100 every month for 10 months, this method allows the business to recognize the $100 as revenue, as and when the receivables are cashed in. 

This is typically used for expensive items where it’s not possible to guarantee regular payments from the customer.

 

Revenue Recognition Methods used by Subscription Businesses

When you buy a pack of batteries at a supermarket or when you buy a car at a dealership with the agreement that you pay it off over 10 months, the revenue transaction is fairly straightforward and simple. 

However, for subscription businesses, it gets a tad more complex. Let’s say a business has two plans and they can be billed monthly, quarterly and yearly. Let’s not forget to include implementation, product training, and other one-time charges. Finally, throw in some discounts. Now, imagine recognizing revenue for a 4 year contract with a 20% discount during the first year, non-inclusive of one-time charges. What if this customer wishes to downgrade after 6 months? 

With multi-year contracts, multiple billing periods, discounts, and one-time charges, subscription businesses often tackle a diverse array of revenue recognition scenarios. The Ultimate Guide for Revenue Recognition explores how ASC 606 compliance plays out in such scenarios and the challenges of revenue recognition for SaaS companies. 

Given the nature of their performance obligations and their use cases, subscription businesses generally prefer revenue recognition methods like 

• Percentage of Completion 
• Point in Time (revenue at delivery or shipment)
• Proportional Performance

 

What’s the right method of revenue recognition for you? 

When choosing a revenue recognition method for a business, one needs to take into account the business model, the customer use cases, the nature of the performance obligations, and how they’re fulfilled. 

Selecting the wrong method could result in inflated or deflated numbers on your balance sheet. This in turn could affect your executive decisions, tax liability, and the confidence of your investors. 

If you’re a SaaS or subscription business, Chargebee can help implement your preferred revenue recognition method into your business processes, automate ASC 606/IFRS15-compliance for your organization and always stay audit-ready. 

 

Learn how Chargebee can help you uncomplicate your revenue recognition process