The Revenue Recognition Principle

How and when revenue is recognized is determined by rules, guidelines, and findings from organizations such the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). These rules and guidelines are encapsulated in the revenue recognition principle, which is consistently reviewed and updated by the FASB.

In some cases, revenue recognition is easy to understand, calculate, and document. Many companies sell products that are delivered to customers immediately, such as e-commerce companies. These companies can recognize revenue immediately.

Other companies, such as subscription-based companies like Netflix, deliver their services over a period of time and must therefore recognize revenue incrementally over the period of time the service is delivered.

Furthermore, revenue recognition becomes extremely complex for B2B companies with complex offerings, such as bundled services or support with subscriptions, non-standard functions/capabilities, or when you agree to some customer acceptance criteria (e.g.,”out clauses”).

So in practice, revenue recognition is extremely complicated for B2B SaaS companies. Therefore, standards boards and regulatory agencies have established complex rules and guidelines in order to put all of these business models under one guiding principle and rein in aggressive revenue recognition actions taken to inflate actual corporate performance of public companies.

What is The Revenue Recognition Principle?

The revenue recognition principle, per the FASB website, establishes the core idea that businesses should “recognize revenue in a manner that depicts the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for these goods or services.”.

The revenue recognition principle is particularly relevant to SaaS companies because most SaaS companies are subscription-based in nature, meaning that they recognize revenue in a slightly different way than most companies. 

Subscription-based companies have varied ways of recognizing revenue that depend on when their performance obligations have been “satisfied”. Because performance obligations can be met at different times depending on your contract structure, recognizing revenue gets confusing and messy for SaaS companies. But that’s where the revenue recognition principle comes in.

Why is The Revenue Recognition Principle Important?

The revenue recognition principle is important for a few reasons: 

• It will help you craft a documented revenue policy for your business 

• You must follow current FASB guidelines for revenue recognition to produce audit-ready financials 

• Your investors take into account your financial metrics, such as total GAAP revenue, in addition to SaaS metrics like ARR when evaluating the health of your business

What is The New Revenue Recognition Rule?

The new revenue recognition principle is called ASC 606, and it was jointly released on May 28, 2014 by both FASB, which oversees accounting principles for private entities in the US, and IASB, or the International Accounting Standards Board, that oversees international accounting practices.

How Does ASC 606 Change Revenue Recognition?

ASC 606 sought to:

• Foster a more robust framework for addressing issues with company’s revenue as they arise

• Allow for companies across industries to compare their financial statements and information

• Require more thorough disclosure so investors and auditors can understand the rationale behind a company’s metrics.

The industries that have seen the effects of ASC 606 the most are those in the telecomm, aerospace, construction, real estate, software, and asset management spaces, as these companies have products and services that take a long time to deliver to customers and therefore would not typically recognize revenue at the moment of sale.

How to Record Revenue Recognition

What are The 5 Criteria for Revenue Recognition?

In order to abide by the revenue recognition principle, businesses usually implement this five-step process: 

1. Identification of the contract with a customer or client.

2. Identification of the obligations and promises made in that contract.

3. Determination of the price of the goods or services.

4. Matching of the price to different obligations in the contract.

5. The recognition of revenue when the organization responsible for reporting completes or satisfies a performance obligation.

How to Audit Revenue Recognition

Complexities in revenue recognition arise when delivering solutions to the marketplace using term subscriptions or perpetual licenses. It is recommended that all companies with term subscriptions, private or public, understand the important concepts and adopt a process for financial reporting based on revenue recognition as early as is practical.

Here are some things that can alter the way your company recognizes its revenue, and things to keep in mind when it comes to adhering to the revenue recognition principle:

• Valuation of your company is impacted by, if not solely determined by, your historic revenue performance.

• If a customer license (via perpetual or subscription license) includes any software modification or customization, revenue recognition will be impacted.

• If you bundle professional services with your customer license (via perpetual or subscription license), revenue recognition is likely impacted.

• If you bundle support with your customer license (via perpetual or subscription license), revenue recognition can be impacted.

• Simply separating contract components (referred to as “contract elements”) doesn’t necessarily affect an “unbundling.”

• How your contract is worded can make a HUGE difference in how revenue is recognized.

• How an investor or strategic acquirer calculates your revenue may differ dramatically from how you report revenue. In the end, how they calculate revenue is the only thing that matters!

• The recognition of revenue for elements within a single contract may not match the line items in that contract. In other words, the allocation of the total revenue of a contract across the different elements within the contract may be made in a manner that is different from your contract under the concept of VSOE – Vendor Specific Objective Evidence.

• There are complex rules and guidelines that determine how revenue is to be recognized, however, there remains a dimension of subjectivity in determining how exactly your company will recognize your revenue. In the end, your auditor will have the final say.

• The more you know about revenue recognition, the better your record keeping, the more you adhere to contracts and terms that simplify revenue recognition, and the more consistency you achieve in your customer licensees, the lower the risk of a disconnect between your revenue recognition methods and results and those of a strategic investor or acquirer.

 Would you rather just talk to the experts about how to ensure consistent adherence to the revenue recognition principle? Reach out to us at Maxio to get guidance and more best practices.