The concept of revenue recognition is well-known to accountants, but not as much for many fast growing business owners in the online courses, training, and subscription type of businesses.
Although it sounds simple, this principle is much more complicated. The reason for this is because for some businesses such as course creators, or subscription services, it is difficult to define the moment when revenue is earned. How and when revenue is recognized is determined by the rules, guidelines, and pronouncements from organizations such the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB).
So, how and when should we recognize revenue? Read on.
Revenue recognition (also known as “rev rec” or “revenue rec”) is an accounting principle which states how and when revenue should be recognized. Typically, revenue must be recognized using the accrual accounting, which requires recording of revenue when it is earned and realized – not when cash is received. Proper revenue recognition is essential for businesses because it allows external stakeholders like analysts and investors, to assess and compare their performance with other companies in the same industry and make informed decisions about their future. Having an accurate revenue recognition system is likewise important in maintaining the integrity and consistency of a firm’s financial reporting.
The accrual and cash basis accounting of revenue recognition differs mainly from the timing of when revenue are recognized or recorded. The accrual method records revenue when it is earned, or when a product or service is delivered to a customer. On the other hand, the cash method recognizes revenue only when the money is received by the company. As a result, different revenue recognition methods may need to be used depending on the size, needs, and complexity of a company's business operations.
Accounting of revenue under the accrual method is important because it allows companies to provide a more accurate picture of their financial performance, especially in the long run. By recognizing revenue when transactions occur, companies can provide a better and clearer insight into their profitability. This is especially important for large and publicly traded companies because it spreads out earnings over time, and prevents aggressive revenue recognition schemes that could mislead investors and other stakeholders.
Meanwhile, the cash-based revenue recognition records revenue when cash is received by the business, rather than when the service or good is delivered to the customer. This method is beneficial for small businesses because it is simple and straightforward. However, this can result in less accurate financial position, as it does not consider liabilities and receivables.
Both accrual and cash basis accounting have their respective advantages. When making decisions, it’s essential for investors to understand the impact of both methods, since they provide different views of financial health and performance. However, it is important to note that the accrual method is accepted under the generally accepted accounting principles (GAAP) issued by the FASB, and is more commonly used by companies in filing their audited financial statements.
Depending on the business model, there are several primary methods that companies can use in recognizing revenue. The most common method is the sales-based method, which requires that revenue is recognized at the time of sale, or when the title to the product or service is transferred from the seller to the buyer. Meanwhile, the installment method allows companies to recognize revenue over multiple periods (years or months) and is usually used for high-value purchases such as vehicles and real estate. Another method is the cost recoverability method, which recognizes revenue only after all expenses related to the sale have been recovered by the seller. In the completed-contract method, all revenue from a specific project is recognized only after the project has been completed. Lastly, the percentage-of-completion method allows companies to recognize revenue of long-term contracts as a percentage of the work completed during the period.
The revenue recognition for coaches, training companies, and subscription services is different from those selling one-time goods or services. Instead of a single-use exchange, the revenues for these businesses typically arrive up-front for services that will still be rendered in the future. Hence, revenue recognition should match performance obligations, which are the services they agree to provide to their clients. As such, the revenue for coaches, trainers, and subscription services should be recognized and recorded when the value of each performance obligation is completed or when services are performed.
This can happen in a single payment or can be divided into multiple installments.
When training companies receive payments up-front, they can choose to recognize revenue evenly over the course of a year. This method can help improve profit margins by allowing the company to better budget for its expenses.
Training companies often use one of the two common payment plans for recognizing revenue: Revenue Recognition and Billing Scale.
Revenue recognition is a fundamental component of accrual accounting and is important for business transparency and financial health. Recognizing revenue allows investors to see how much a company has earned from providing services, and helps businesses manage their cash flow more effectively.
Billing scale is another common payment plan used by training companies. Under this plan, companies recognize revenue as payments are received from customers. This approach can help businesses better manage their cash flow, as they are not waiting for customers to make full payments before recognizing any income.
When a customer pays in installment, companies only recognize revenue at the time of collection. This is because there is always a possibility that a customer will default on their payments (stop paying). And if this happens, the company will not have received any revenue.
When there is an uncertainty in the collection of payment, then an allowance should be made for doubtful accounts. This means that some of the revenue that has been recognized may have to be written off if it turns out that the customer cannot or will not pay.
If companies aren't fully sure that any payment will be received, then no revenue should be recognized. This is because it is highly likely that the customer will default on their payments, and the company would not actually receive any revenue in this case. Read more on how to recover failed payments.
Subscription businesses should recognize revenue gradually over the course of a subscription, usually over a period of months or years. This is done in order to accurately reflect the value of the service being provided to the customer. Deferred revenue can be classified as a liability because it's an obligation to provide a service for a certain length of time.
Accurate revenue recognition helps subscription businesses operate more efficiently by avoiding immediate or untimely recognition of revenue. This allows companies to better manage their cash flow and understand their true financial performance. Deferred revenue is important for subscription businesses because it allows you to handle cancellations and changes in customer behavior.
Revenue recognition is critical for public companies and businesses with over 25 million USD in annual revenue. It helps these organizations track their performance and make informed decisions about their business operations. Revenue recognition depends on the type of business and the country/region where it is located. As such, it can be quite complex and tricky to implement, especially as a business scales up.
Coaches, trainers and subscription companies can decide which revenue recognition method to choose by following the 5-step model described in the ASC 606 guidelines:
Step 1 → Identify the signed contract between the seller and customer
Step 2 → Identify the distinct performance obligations within the contract
Step 3 → Determine the specific transaction price (and other pricing terms) stated in the contract
Step 4 → Allocate the transaction price over the contract term (i.e. multi-year obligations)
Step 5 → Recognize the revenue if the performance obligations are satisfied
These five steps help coaches, trainers and subscription services decide which revenue recognition method is best suited for their business model. If you are still unsure which method is the best, you can start tracking your payment plans revenue to see how customers will behave.
Payment plans revenue can be tracked in several ways depending on the value of item, the actual money received and what is left to be paid.
Order/Contract value, Account Receivable - value of the item sold
Cash value, Earned/Realized Revenue - actual money received,
Future or deferred revenue, balance - what’s left, what should be paid
One of the ways coaches, trainers and subscription services can track payment plans is by the value of the item sold. This can be done by considering the contract value of the products/service which is the worth of the product/service over the course of its lifetime. Alternatively, these businesses can track their payment plans as accounts receivable (AR). This means that the product or service has been delivered (or is being delivered) to a customer but the payment is yet to be fulfilled.
Under the accrual basis of accounting, when you have satisfied all the criteria for revenue recognition, you record all of the revenue from the contract.
Once the actual money is received, the business faces a new ambiguity: cash value vs realized revenue.
Recognizing revenue differs depending on whether it's cash or realized (realized means actually received by the company). In this case, cash value would be when the customer pays in advance, while realized revenue would be when the customer takes possession of and uses the product or service.
Revenue is earned when such goods/services are transferred, and revenue is realized when cash or claims to cash (receivable) are received. When selling inventory, revenue recognition typically occurs at the date of sale, interpreted as the date of delivery. When rendering services, revenue recognition typically occurs when services are completed and billed.
The Actual Money Received will show you how much cash value the customer received, while the Realized Revenue table will show you how much money was actually earned after sales taxes were applied. The Realized Revenue table is always more accurate because it considers any sales taxes that were paid on the purchase.
In order to comply with the new revenue recognition standard, ASC 606, subscription businesses need to have a balance payment plan. This means that the customer will be invoiced for the services they receive on a monthly basis. The customer will then be responsible for paying that amount in full within 30 days.
Deferred revenue is a liability for businesses. When using accrual accounting, companies recognize revenue when the related delivery takes place, rather than when the fee is received. This allows for quicker booking of income, which can result in a more accurate financial picture. To calculate deferred revenue, businesses must first identify all cash payments that have been received for goods and/or services that are still to be delivered or rendered. This amount increases when a company receives additional deposits or advance payments and decreases by the revenue earned during the period.
Revenue recognition is a critical accounting practice that determines when and how much revenue a company can report. Generally, companies follow established rules and guidelines from organizations like the IASB and FASB, in making revenue recognition decisions. Depending on the nature of the transaction, businesses may recognize revenue immediately or over time. For example, subscription-based companies typically recognize revenue incrementally, as customers make payments over time. In contrast, companies that sell physical goods may recognize revenue upon delivery of the product.
When revenue is recognized, it means that a contract with a customer or client has been completed and the organization responsible for reporting can now record the associated revenue. This process involves a few key steps, which are important to ensure that revenue is reported accurately.
The first step is to identify the contract with the customer or client. This helps to determine what obligations and promises have been made in the contract. The second step is to determine the price of goods or services under the contract. This helps to match the price to different obligations in the contract. The third step is to recognize revenue when organization responsible for reporting completes or satisfies performance obligation. This ensures that revenue is reported correctly and in a timely manner.
A performance obligation is the unit of account for the goods or services promised to a customer in a contract. The scope of a performance obligation must be identified in order to recognize revenue. In order to determine the transaction price, allocate it to performance obligations and recognize revenue when (or as) the entity satisfies a performance obligation. A customer has several options for additional goods or services after receiving what was promised in the contract. The performance obligations in a revenue recognition contract can include licensing of intellectual property, contract modifications, contract costs, and loss contracts. The effective date and transition clauses in a revenue recognition contract should be carefully considered to ensure that all contractual obligations are met.
The transaction price in a revenue recognition contract is the amount of money that the customer pays to the vendor. This may include fixed amounts set forth in the contract, variable amounts, or both. The transaction price might also include adjustments for significant financing arrangements (time value of money), or the fair value of any non-cash consideration received.
The basic rule is that the transaction price should be allocated to a performance obligation that best reflects the amount of consideration to which the company expects it will be entitled when it satisfies each performance obligation.
Revenue is recognized when there is a critical event that has taken place, when the product or service has been delivered to the customer, and the amount is easily measurable.
Public entities are required to disclose a great deal of information about their revenue and cash flow.
Nonpublic entities have the option to elect not to provide certain disclosures, and disclosure requirements for interim periods are reduced in scope.
Revenue recognition can get complicated as a business scales up, so it's important to have a clear understanding of the requirements before starting. Different types of businesses need to take into account revenue recognition, such as subscription-based businesses and digital goods businesses.
Revenue is recorded in the income statement when it is earned, regardless of when the payment is received. This means that businesses can record revenue even if a client pays for the service later than expected.
ASC 606 and IFRS 15 provides a uniform framework for recognizing revenue from contracts with customers. The old guidance was industry-specific, which created a system of fragmented policies. The updated revenue recognition standard is industry-neutral and, therefore, more transparent.
Revenue projections are important because they help companies manage their expectations and ensure that they are realistic. By creating a revenue projection, a company can see how much revenue they are likely to bring in over a certain period. This helps them to budget appropriately and plan for future expenses. Additionally, revenue projections can help remove inconsistencies and weaknesses in a company's accounting practices.