Learn the 5 Steps to Recognizing Revenue

The practice of determining when and how income should be recognized as part of an organization’s accounting cycle is known as revenue recognition, or “rev rec,” informally. Even though there are far too many intricate nuances and procedures to cover in one blog post, it’s crucial to comprehend the fundamentals of revenue recognition, particularly if your business offers services through term subscriptions or license agreements.

Why Is Revenue Recognizance Important?

The Securities and Exchange Commission has designated the FASB (Financial Accounting Rules Board) as the entity in charge of establishing the accounting standards for American businesses. These requirements are specified in the Accounting Standards Codification (ASC), which is periodically revised. ASC-606, which establishes new revenue recognition requirements for all businesses that supply products or services, is one such modification that took place in 2020. The goal of ASC-606 is to increase consistency across sectors for a more transparent and comparable revenue recognition system.

Because of the characteristics of the industry—sales negotiated agreements, term subscriptions, expert services, etc.—revenue recognition was always a challenging topic for SaaS companies. However, to remain compliant, it is necessary to adhere to the newer, more intricate criteria established by ASC-606. In addition to being needed by auditors, compliant revenue recognition can be extremely important to your company’s valuation in the event of a strategic investment or acquisition.

How Does the Revenue Recognition Process Work in Five Steps?

Step 1: Determine the terms of the client agreement.

This is one of the easiest stages of revenue recognition. The agreement must meet the following requirements, among others:

  • Possesses the consent of both parties
  • Outlines each party’s obligations and rights.
  • Specifies the terms of payment
  • A commercial substance is indicated (the transaction will cause a significant change to future cash flow)
  • Implies that payment for the provided goods or services will be made to the vendor.

Step 2: Determine your contractual performance requirements.

It is required by ASC-606 to determine your “distinct performance requirements,” which is a seemingly straightforward requirement. A deliverable, such as a good or service, is a performance obligation. But what distinguishes a performance obligation?

If a performance requirement benefits the consumer on its own, you can classify it as different. Consider the case where the performance requirement is a piece of machinery. Once the equipment is in the customer’s possession, your performance obligation is over. You might also offer a limited guarantee for future repairs when you sell a piece of equipment. Since the consumer can utilize the equipment in this situation without utilizing the warranty service, the item and the warranty are separate entities.

On the other hand, SaaS transactions frequently contain performance commitments that appear to be independent but are not. Training, personalization, or customized installation are a few examples. Consider improving a hospital’s computer network with specialized software integrations that link to current systems. The hospital’s staff will want training from your business to use the software. Although the design, installation, and training may appear to be separate deliverables, their cohesive operation is essential for the hospital to be able to use the new network.

Step 3: Calculate the total cost of the transaction.

Another relatively simple step in the revenue recognition process is this one. The whole cost of the items or services you are offering should be stated in your contract. Discounts, rebates, and bonuses are factors that could have an impact on the price. You might also need to take sales-negotiated agreements into account in more complicated instances.

Step 4: Assign a cost to every performance responsibility.

You must figure out how much of the overall price is allocated to each performance obligation if there are multiple them. What would the price be for a performance obligation if it were sold as a standalone service? Your Standalone Selling Price is that (SSP).

It can be difficult to assign an SSP to each commitment at times. If determining a solo price is difficult, it may be helpful to assess the respective separate prices of each duty and give each one a percentage. Consider how you would slice a pie. You will be able to calculate the proportional value of a challenging performance obligation once you have determined the other segments.

Step 5: After completing or delivering the performance obligation, recognize the revenue.

When the items are delivered or the services are provided and control is turned over to the client, the revenue recognition process’ last step takes place. Once they begin to receive the benefits of the product or service, the client is deemed to be in charge. You can recognize revenue once a performance obligation has been met.

The easiest illustration of this is retail purchases. The buyer purchases an item from you takes it out of the store, and you record the sale as income. It’s more complicated for SaaS organizations. You may have a technical support contract with the customer for a whole year; over time, the customer will gradually take over your performance duty to provide technical assistance. In such a situation, you would record the revenue as it was earned over the course of the year, perhaps weekly.

Work 365 is a subscription billing automation software that helps Microsoft partners and SaaS companies to streamline recurring revenue and improve overall growth.

Written by Brian Moose

I work at Work 365 - billing and provisioning software for Microsoft Partners and SaaS companies.

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