Why Proper Revenue Recognition is Essential for Understanding Your Company’s Financial Health
If you own or manage a business, you’ve likely recorded revenue in your financial statements using some sort of systematic method. The accounting rules for recording (or “recognizing”) revenue in financial statements can be confusing, especially among different types of business transactions, so it’s crucial to build an understanding of what revenue recognition is and how it impacts your financial statements.
What Does It Mean to Earn Revenue?
In a general sense, earning revenue means delivering something of value to your company’s customers in exchange for payment (or a promise to pay). Money collected from the sale of consumer goods, fees charged for delivering subscription services, and fees due for providing consulting services are all examples of revenue. In order to earn revenue, the goods or services must be transferred to the customer, and the receipt of consideration (money) must be reasonably certain. Revenue should be distinguished from profit, however, which is what’s left after subtracting expenses from gross revenue. It’s also worth noting that although revenue can be indicative of cash flow, it is not necessarily the same thing, as there are often timing differences between when revenue is recorded and when cash is received.
What is Revenue Recognition?
Revenue recognition simply refers to the accounting rules that determine when a company records revenue for the products or services it delivers. To establish consistency when comparing financial statements of similar companies, rules are put in place to guide what qualifies as revenue and when to record it. This not only helps potential investors, banks, regulators and others evaluate a company’s financial statements, but it also helps business owners/managers better understand how their company is truly performing.
Take, for example, a company who sells a consumer good without a warranty or associated service. In this case, revenue is typically recognized after the cash has been exchanged and the consumer is in possession of the purchased good. For other companies (e.g., technology, SaaS, media, real estate, construction, medical), the revenue recognition process is often more complex. Consider a SaaS company that charges and collects an annual subscription fee at the beginning of a one-year contract. Since the company has not yet provided the customer access to the subscription service at the beginning of the term, none of the money collected is considered “earned” and, therefore, the fees collected are “recognized” as revenue over the future subscription period. If the company were to record the front-end fee as revenue when received, it would be ignoring the fact that it has an obligation to provide a service to the customer over the next year.
How Does Revenue Recognition Affect My Business?
Proper revenue recognition helps keep a company’s financial statements accurate so that users of those financial statements, whether company management or third parties, can better understand the true financial performance of the business. Some owners can be tempted to recognize transactions incorrectly as revenue in an effort to “look better” to investors, bankers, board members and others. Doing so, however, can cause problems down the road and adversely affect your company’s reputation (as well as your own). In some cases, improper application of revenue recognition rules may even have legal repercussions if users are led to believe that proper accounting methods have been applied. If you have dreams of someday selling your business, or even raising money from investors, it’s important to show a true representation of how your business is performing, and you’re better off maintaining accurate financials from the start.
Following the rules of accounting, often referred to as generally accepted accounting principles (or “GAAP”), helps maintain your financial statements as a good indicator of your business’ financial health and helps others evaluate your company’s financial performance against expectations, benchmarks and other similar companies in your industry. It seems like a simple principle, but proper revenue recognition can have far-reaching implications throughout your organization.
Updates to revenue recognition rules were recently introduced and take effect for most companies beginning January 1, 2019. For many companies, the rule changes will significantly impact how revenue is recognized going forward and requires careful analysis to properly transition from current practices. We’ll explore these changes in our next post in this series, exploring revenue recognition and what it means for your business.