Revenue Recognition Methods

What is Revenue Recognition?

Revenue recognition is the process of recording and reporting the inflow of revenue in a company’s financial statements. It involves determining when and how revenue should be recognized based on the completion of performance obligations, transfer of control, and the amount that can be reliably measured. This accounting principle ensures that revenue is recognized in a timely and accurate manner, providing transparency and enabling stakeholders to assess a company’s financial performance.

When analyzing financial statements, revenue figures take center stage. Ensuring proper and accurate revenue recognition, measurement, and presentation is crucial for your organization to work with the right data for conducting business. While there are various methods of revenue recognition, not all of them suit every business model.

The Revenue Recognition Processes

The process of revenue recognition involves a series of steps that guide companies in properly recording and reporting their revenue in financial statements. These steps ensure that revenue is recognized in a timely and accurate manner, providing transparency and enabling stakeholders to assess a company’s financial performance. 

1. Identify the contract with a customer: Establish criteria for forming a contract with a customer.
2. Identify performance obligations in the contract: Determine distinct obligations within the contract.
3. Determine the transaction price: Consider factors when establishing the price for goods or services.
4. Allocate the transaction price: Guidelines for distributing the price among separate obligations.
5. Recognize revenue when or as the entity satisfies a performance obligation: Outline the recognition of revenue as obligations are fulfilled.

In today’s increasingly complex business landscape, the traditional single revenue model is fading away. Businesses now must offer flexible and personalized pricing, billing, and monetization options. Revenue recognition, already a complex process, has become even more challenging due to changing accounting standards and regulations.Centralize your revenue streams with a single revenue recognition solution. Achieve compliance with the new ASC 606 & IFRS 15 standards. Automate calculations, streamline your period-end close, and gain a comprehensive view of your organization’s revenue—both recognized and deferred.

Revenue Recognition Methods:

1. Sales-basis method: The sales-basis method recognizes revenue at the time of sale, which is when title transfers to the buyer. This method is commonly used for transactions involving the sale of goods, where revenue is recognized once the customer takes legal ownership of the product. It provides a straightforward approach to revenue recognition, as it aligns revenue recognition with the transfer of ownership.
2. Completed-contract method: The completed-contract method records revenues and expenses at the end of the contract. This method is typically used for long-term projects where it is difficult to reliably estimate the percentage of completion. Under this method, revenue and expenses are recognized only when the contract is completed, providing a more conservative approach to revenue recognition.
3. Cost-recoverability method: The cost-recoverability method delays profit recognition until all project expenses are recouped. This method is commonly used for projects where there is uncertainty regarding the recoverability of costs. Revenue is recognized only after all project costs have been recovered, ensuring that profit is not recognized until the project is deemed financially viable.
4. Percentage-of-completion method: The percentage-of-completion method recognizes revenues and expenses as a percentage of work completed, which is particularly common in long-term contracts. Under this method, revenue and expenses are recognized proportionally as the project progresses, based on the percentage of work completed. This method provides a more accurate reflection of the project’s financial performance over time.
5. Installment method: The installment method records proportionate profit upon installment receipt, making it suitable for transactions with unreliable customer collections. Revenue is recognized as payments are received from the customer, with profit recognized proportionally to the amount of cash collected. This method allows for more conservative revenue recognition when there is uncertainty about the collectability of payments.
6. Brokerage agreement: A brokerage agreement adheres to proprietary rules for brokers, following IRS and SEC guidelines. This method outlines specific rules and regulations that brokers must follow when recognizing revenue from brokerage services. It ensures compliance with tax and regulatory requirements, providing a standardized approach to revenue recognition in the brokerage industry.
7. Accrual method: The accrual method initially records prepayments as assets, reclassifying them as expenses upon goods delivery or service completion and acceptance. This method matches revenue with the expenses incurred to generate that revenue, providing a more accurate representation of the financial performance of a business. It recognizes revenue when it is earned, regardless of when cash is received.
8. Appreciation method: The appreciation method allows real estate agents to reduce gains from selling properties at appreciated values. This method recognizes revenue based on the increase in the value of the property over time. It allows for the recognition of revenue as the property appreciates, providing a more accurate reflection of the economic benefit derived from the sale.
9. Proportional performance method: The proportional performance method is a modification of the percentage-of-completion method for profit recognition. It recognizes revenue and expenses based on the proportion of performance completed, similar to the percentage-of-completion method. However, under this method, profit is recognized based on the proportion of performance completed, rather than the proportion of costs incurred.
10. Deposit method: The deposit method is used for deposits subject to cancellation agreements. Revenue is recognized when the deposit is received, but it is recorded as a liability until the cancellation period has expired or the customer has fulfilled their obligations. This method ensures that revenue is not recognized until it is certain that the deposit will not be returned.
11. Transactions Under Bill & Hold: The transactions under bill & hold method is applicable to prevent fraudulent transactions aimed at inflating a company’s assets. Under this method, revenue is recognized when the customer is billed, even if the goods are not physically delivered. However, specific criteria must be met, such as the buyer’s request for the bill & hold arrangement, the goods being identified separately, and the goods being ready for physical transfer.

These various methods provide businesses with flexibility in recognizing revenue based on the specific circumstances of their transactions, ensuring accurate and reliable financial reporting.

Warning: Your ERP May Not Support All Revenue Models

Finance teams often resort to Excel because their ERP platforms lack essential features. For instance, many businesses adopt subscription-based and hybrid pricing models, but popular ERPs may not support them or require cumbersome bolt-on solutions. Building spreadsheets to accurately recognize revenues per ASC 606 guidelines becomes a time-consuming task, potentially leading to increased audit fees or hiring more staff. Maintaining these spreadsheets, data scrubbing, and report generation can overwhelm your finance team, diverting their focus from strategic planning.

Spreadsheets are inherently unsuitable for real-time synchronization with source data, resulting in outdated information. Additionally, collaboration is challenging, and sharing spreadsheets is cumbersome. Inefficient Order to Cash (O2C) processes, relying on spreadsheets, can impede business operations, as evidenced by a classic Genpact study indicating that 7–12 percent of combined revenue in working capital is trapped in inefficient O2C processes at top global organizations.¹

¹ Smarter Order to Cash Processes, Genpact

Certinia Supports Your Revenue Recognition Methods

Irrespective of your business models or chosen revenue generation methods, solutions like Certinia Revenue Management equip your finance team with the tools needed to meet the entire business’s demands. Certinia automates recognition calculations, eliminates error-prone spreadsheets, and aligns with key revenue recognition standards. Built on the Salesforce platform, Certinia seamlessly integrates with Salesforce CRM and other Certinia ERP solutions, ensuring interconnected customer data.