The Inside Scoop on Revenue Recognition
Gain insights into revenue recognition and its significance in financial reporting. Explore the implications of ASC 606 and discover strategies to optimize your process. Stay informed about common AR challenges and learn how automation can enhance your workflow.
Revenue recognition has been making headlines over the past few years, not for the right reasons. Improper revenue recognition makes up about 60% of SEC fraud cases as companies attempt to show investors that they have healthy or superior cash flow.
Every account receivable team knows that revenue recognition is the bedrock of sound financial reporting. And they also know how recording payments can be a common AR challenge. And if you're using manual AR processes? It can feel downright impossible.
Once you mix in confusion around accrual vs. cash-based accounting, it's easy to see how complex revenue recognition is.
That's why we're diving deep into this topic, including the recent implementation of ASC 606 and how you can optimize your revenue recognition process.
The ABCs of Revenue Recognition
In short, revenue recognition is an accounting principle that says that revenue must be accounted for when earned. The key word here is "earned" because that can mean many different things. For example, is revenue earned when you complete a service or deliver the goods or when you get paid?
How you recognize earnings can affect your accounting style, among other factors. The two accounting methods we use today are:
- The accrual method counts revenue when earned, even if payment still needs to be received.
- The cash method counts revenue when it comes in, regardless of when services and goods are delivered.
Whichever method your accounting team chooses, you should stick with it. Your revenue recognition is the bedrock of your financial reporting process. If there are inconsistencies in your revenue recognition, making informed decisions regarding company spending is difficult.
Does Your Company Need Revenue Recognition Standards?
All businesses require an accounting standard for consistent records and revenue reporting. However, certain organizations must abide by an accounting standard more than others. Some types of companies that commonly use a standardized revenue recognition process are:
- Public companies or business entities with over $25 million in revenue
- Startups that track accrued revenue
- Subscription businesses
Does the GAAP Mandate the Accounting of Revenue?
The Generally Accepted Accounting Principles (GAAP) support the accrual method. In other words, businesses should record revenue when it is "earned," not necessarily when the cash hits your bank account. However, this relates specifically to income statements.
In a given accounting period, revenue is only recognized when the payment is complete, and there is confidence that it will be received.
That said, this process can still get confusing. What defines a complete payment, and what confidence level is enough to record revenue without the cash in the bank? Not to mention all the industry-specific standards that go into accounting. And how to the delivery of promised goods fit into this?
Mounting questions instigated the new revenue recognition standard, the Accounting Standards Codification (ASC) 606: Revenue from Contracts with Customers.
What Is the ASC 606 and How Does It Affect Revenue Recognition?
ASC 606 is a standardized framework to help guide businesses better concerning revenue recognition. Developed by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) aims to reduce discrepancies and clarify the revenue recognition process with this accounting standards update. Rather than have businesses rely on dated, industry-segmented rules and regulations, the ASC 606 provides a single roadmap for all organizations.
According to this update, revenue must be recognized when goods and services are delivered, regardless of the payment date.
While it sounds straightforward, adhering to ASC 606 has been challenging for business owners, accountants, and auditors. According to the Journal of Accountancy, 48% of accountants found it challenging to identify whether or not management correctly applied ASC 606.
Part of the struggle comes from the flexibility of the five main criteria related to the rule.
What are the 5 Criteria for Revenue Recognition from ASC 606?
When the ASC 606 came into effect in early 2019, companies would need to look to core principles of recognizing revenue rather than use older, industry-specific approaches. The five criteria used are:
- A contract with a customer with commercial substance includes all committed parties, assigns rights and payment terms, and indicates payment collection information.
- Performance obligations that are clearly defined regarding goods and services rendered. There can be separate performance obligations within a single contract.
- Transaction prices, including discounts, credits, fees, incentives, changes in cost, and customer rights, should be identified.
- A link to performance obligation and transaction rights that also highlights that all parties understand and agree to the contract. All transaction prices should be based on the fair value of the goods or services.
- Revenue is recognized when obligations are met.
In other words, the new revenue recognition standard prioritizes documentation and delivery. Let's look at the idea of deferred revenue. If a customer pays for goods or services in advance, that payment is considered unearned revenue until the business delivers the promised goods and services. Earned revenue is when a delivery or an obligation is met - not when the payment is sent.
ASC 606 Revenue Recognition Examples
So, what does ASC look like in practice? Here are two examples:
- An investment fund sends a monthly newsletter as a separate revenue stream. The annual cost is $1,000; the customer pays in full when signing up. The value of each email is $83.33. Since the single performance obligation is fulfilled each month, $83.33 would be recorded monthly.
- A marketing agency charges a technology company $10,000 monthly for several services. The performance obligations break down to $5,000 quarterly strategy, $1,000 for social media assets, and $4,000 for content assets. One client likes to pay quarterly. As a result, each obligation can be recorded when it's fulfilled during each month. So instead of recording $30,000 for a quarter, the company must record service as it's performed monthly.
How Can Automation Help You Recognize Your Revenue?
Automation helps organizations speed up revenue recognition and prevent fraud without sacrificing accuracy. Through an automated workflow, AR teams don't need to manually input data or match invoices and payment data by hand. Instead, they can focus on more strategic tasks and challenging accounts while technology takes care of the rest.
That said, you'll want to set up your payments automation solution for success, including a customized integration with your ERP. But there are some other things you should look for in a revenue recognition solution, such as:
- In-depth payment analytics
- Meets compliance standards
- Customizable, on-brand payment portals
- Ability to implement advanced payment features, such as convenience fees, zero-fee options
- Access to an extensive bank network for ACH and bank-to-bank transfers
- Tokenized security to protect personal and sensitive information
- An easy-to-use interface within your ERP
- Immediate payment, notarized receipts
- Real-time bank verifications
- Multi-currency, subsidiary support
- Automated collections workflow
When looking for an app to help automate your payments, ensuring that you choose an end-to-end platform can ensure that your financial reporting is standardized across the board.
4 Tips for Better Revenue Recognition
1. Stick to the Acctual Method
It may not feel as accurate as cash-on-hand, but the accrual method is far closer to ASC 606 and easier to monitor. Ideally, all revenue streams should funnel through the same payment system and be recorded as soon as the payment is delivered.
To reduce potential pressures on cash flow, reviewing the terms and services linked to each revenue stream can be helpful. You will want to simplify the systems around delivery, reporting, and invoicing to prompt payments. For example, your accounts receivables team may enact an early pay discount to encourage timely payments.
2. Stay Attuned to Regulation Changes
The significant regulatory shift from rules-based to principle-based standards reminds us that staying on top of industry changes is critical. Looking toward the future and recognizing positive and negative trends can help you identify potential best practices before they are mandated. The International Accounting Standards Board and the Financial Accounting Standards Board are two essential regulatory bodies to keep up with.
3. Automate Your Systems
The digital transformation of the past two decades was only the first step toward actual efficiency. Digital data entry into ERPs isn't enough for accounts receivable to keep up with a scaling company or compliance changes. Automation provides additional support for your accounting professionals.
Now your AR team can automate invoicing and payments, receipts, collection workflows, and more. All while ensuring that the books adhere to the updated revenue recognition standard. These enhanced features can help your department reduce spending and fraud while promoting healthy cash flow.
4. Map Your Process from Order-to-Cash
Every policy and process related to revenue recognition matters. This includes everything from order management and billing to renewals and collections. Capturing in-depth analytics into your payment process can help you locate bottlenecks and areas to revisit. Optimizing the entire pipeline is the best way to ensure standardized and timely revenue recognition.
Optimize Your Payment Process Today
Known as the Venmo of B2B transactions, Paystand provides a compliant solution for end-to-end payments visibility and customization to accelerate AR processes. Our platform integrates with all major ERPs, making it easy to automate invoicing, payment processing, matching, collections, sending receipts, and other essential functions.
See it live in a customized demo to determine if Paystand suits your team. Or see how much you can save with our AR Health Calculator.