What is revenue recognition and why is it important?

Earning cash as a business is exciting. However, let’s pump the brakes for a second before you immediately recognize that revenue. Has your business actually earned the revenue?

The revenue recognition principle, a feature of accrual accounting, requires that revenues are recognized on the income statement in the period when realized and earned—not necessarily when cash is received.[i]

As the name implies “rev rec” is all about recognizing – or documenting – monies that you’ve earned at a particular point in time. In the standard product-sales model, revenue can be recognized when an order is delivered. For example, your company sells a laptop, it gets shipped, the customer’s credit card gets charged, and you recognize the revenue transaction immediately.

However, today’s world is more complicated than that. For example, let’s say you ship a three-year SaaS security product with that laptop and charge the customer $360 for it. You cannot yet recognize the full value of the annual subscription revenue for the security software that came with the laptop.

Why not? The company earned the money, right?

Well, not completely—yet. Let me explain.

You cannot technically “count” the money for something that you haven’t yet delivered. In the case of the three-year software subscription, you have yet to deliver next year’s or the year after’s software service. So technically you haven’t earned it.

And while you could account for the full three years’ subscription payment, there are two compelling reasons to wait and to accrue it in the period when it was delivered: reason one, it’s the law, so, that’s very important. Reason two, and most importantly for your customers, it’s a fair thing to do.

We’ll start with “because it’s a fair thing to do.”

The best way to explain this tenet is to use the above software subscription example. Let’s say you’re the consumer who bought the subscription. And a year into using the service, the software company is sold to another company. The good news here is that the new company will inherit your two years of liability to fund the service, and thus keep the original company’s contract with you, the consumer. This is the fair and right thing to do.

Now let’s talk about “because it’s the legal thing to do.”

In the above example, the acquiring company did the fair thing. But what if they didn’t do the right thing? What if they took revenue credit for the remaining two years and shut the software service off?

Well, besides making the customers mad, legally, they could get into a lot of trouble for doing this.

You see, a subscription is a liability, the same as if the company leased a new car. If the company stopped making payments on that car, a burly tow truck driver would show up at the office and tow it back to the leasing company.

Also, taking early credit is a legal violation because it skews the books. Taking full credit for the subscription on day one makes the company look more profitable that it really is, because they still owe 359/360ths of the service delivery expense!

That’s why accounting rules and regulations are put into place; to protect consumers, employees, investors, and other interested parties. Toward that end, GAAP guidelines require that companies accrue for liabilities such as annual subscriptions, warranties, and other time-based obligations. If they take full credit up front without accounting for the monthly liabilities, they will fundamentally be overstating their profits as they haven’t given the customer the service, and this will be a cost to the company in the future. And that’s not good.  

But doing rev rec and accrual accounting correctly is hard. Right?

Yes!

Well, it can be!

Revenue recognition can be technically challenging and operationally cumbersome for many and adding a recurring revenue model can make it even more complicated. 

Most recurring revenue streams like subscriptions are treated as services from an accounting standpoint. This changes how revenue and expenses are recognized. Accountants often try to do this using separate schedules on spreadsheets, manually entering revenue numbers into the accounting system at the end of the month. Ugh.

I call this “swivel chair computing.” Copying data from a spreadsheet, and then pasting it into an accounting program. Copying data from a spreadsheet, and then pasting it into an accounting program. Rinse and repeat. You get the picture. It’s very inefficient and prone to errors. And that’s not good in the accounting world.

The solution: automate.

Using automation, whether it’s done via programming or via a built-in back-office system, is the key to proper revenue recognition. For me, I prefer using automation that’s already part of an ERP system like NetSuite, vs programming it myself. I mean, I could do it, but why reinvent the wheel?

In the NetSuite solution, they have a feature called Revenue Management, which streamlines the rev rec process by creating revenue rules for each product and linking them to contract line items. The assigned schedule is used to automatically recognize revenue, promote consistent compliance, and make the closing process smoother.

So no more achy neck copying and pasting. And, way better accuracy and compliance.

Bonus: If you’re a startup looking for additional funding, having clean books where rev rec is done properly will show potential investors that your P&L is accurate, and not distorted by taking early credit for a recurring liability. (They love that stuff, trust me!)

Key Takeaways

• The revenue recognition principle, a key feature of accrual-basis accounting, dictates that companies recognize revenue as it is earned, not when they receive payment.
• Revenue recognition standards can vary based on a company’s accounting method, geographical location, whether they are a public or private entity and other factors.
• Accurate revenue recognition is essential because it directly affects the integrity and consistency of a company’s financial reporting.

• Creating revenue rules and then linking them to the contract is a critical requirement in ASC 605 and 606.

• Small, privately held companies don’ have to follow GAAP, however it’s still the right thing to do, especially if the company is looking for additional funding.

The Bottom Line:

The bottom line is that you cannot immediately take full revenue credit for certain sold items such as subscriptions, warranties, and other services that occur over time. It’s neither legal nor fair. But accounting for these items, i.e., accruing for them, can be a real hassle if done manually with spreadsheet schedules. Your best option is to automate these processes and do so with an integrated back-office system like NetSuite.

[i] Revenue Recognition: What It Means in Accounting and the 5 Steps (investopedia.com)