What Is the Revenue Recognition Principle in Accounting?

There are two basic ways you can recognize revenue in your company - using either cash accounting or accrual accounting. Cash accounting recognizes revenue when payment is received from the customer. Accrual accounting recognizes revenue as it is earned, rather than when the payment is received.

This important accounting principle is most commonly used in insurance contracts. However, every subscription-based company has the potential to benefit from the revenue recognition principle.

What Is Revenue Recognition and Why Is It Important?

ASC 606 revenue recognition is based on the core principle that subscription businesses shouldn't realize the revenue from contracts until they earn it; they should recognize revenue when they've performed the contractual obligations attached to that revenue.

This concept is important because it leads to better financial reporting and a more accurate assessment of your company's financial well-being. Under this model, revenue that hasn't been realized is considered deferred revenue, which acts as a liability on financial reports like your income statement.  

When recognizing revenue this way, you ensure that your top-line revenue aligns with your incurred growth and churn expenses.  

The 5 Accounting Principles of Revenue Recognition

This revenue recognition model includes five accounting principles. All of these revenue recognition standards must be met according to GAAP accounting principles for subscription-based businesses.

Here's how to incorporate them into your accounting process.

1. Identify the Contracts With Customers

The first thing you need to do is develop clear, concise contracts with your customers. These contracts should include the following:

1. Party Knowledge and Agreement: Both parties involved (the buyer and seller) must have knowledge of the contract and agree to the terms. This can be in writing, verbal, or implied.
2. Transfer Identification: You must be able to identify the point of transfer of goods or services from the seller to the buyer. For example, a SaaS market analysis solution may consider access to the service each full month as a clear transfer of service.
3. Payment Terms: The payment terms associated with the contract must be clearly identified. This includes the amount of money the seller expects the buyer to pay, on what dates, and in using what payment methods.
4. Commercial Substance: The contract must result in a reasonable product or service being delivered to the buyer.
5. Reasonable Expectation: The seller must have a reasonable expectation of payment. For example, if you're giving away a free ebook, there is no reasonable expectation that the client will sign up and pay for your premium services.

2. Identify the Performance Obligations

As a subscription product or service seller, you are obligated to deliver those products or services to your customers. However, it's important to determine your performance obligations under the contract.

For example, let's say you own a SaaS investing data solution. You deliver data to your customers once per week for $100 per month. Based on your service terms, your performance obligations are to provide content every week to your customers.

It's important to note each point of delivery because you'll need to assign a value to them later.

3. Determine the Transaction Price

The transaction price is the total price of the contract. For example, if you sell a one-year service for $1,000, your transaction price is $1,000. It's the amount of money you expect during your collection of payment.

4. Allocate the Transaction Price

Allocating the transaction price is at the core of revenue recognition practices because it determines when you can count revenue as an asset rather than a liability in your accounts receivable department.

During this step, you define a set price for each performance obligation. Keeping with the investing intelligence SaaS example above, let's say you charge $100 per month for weekly investing intelligence data.

If all data provided is equal, it's worth $25 each time you provide it. On the other hand, the first data release of the month may be more valuable than the others. In this case, you may allocate $40 in revenue recognition to the first week of the month and $20 per week after that in the typical four-week month. The key here is to allocate a reasonable price to each obligation you have as part of the contract.

5. Recognize Revenue When Contractual Obligations Are Fulfilled

The recognized revenue standard means that revenue should only be recognized when the contractual obligations are fulfilled. If all data you provide is equal, and you charge $100 per month for weekly data releases, you'll recognize $25 in revenue per subscriber per week as soon as you release the data each week.

The revenue recognition concept works just as well for annual recurring revenue as it does for monthly recurring revenue. For example, let's say your service costs $1,200 per year. Under your model, the delivery of your service is based on monthly access to your online tool. This means that you can recognize $100 in revenue from each customer on the books at the end of each month.

The key here is to treat money-in as a liability until you've met the contractual obligations associated with that money.

How Revolv3 Can Assist With Revenue Recognition

Incorporating revenue recognition into your accounting practices doesn't have to be difficult. As technological innovation continues, many business processes are becoming easier to manage. A solid billing platform like Revolv3 can help.

Revolv3 comes with several state-of-the-art tools that will make quick work of revenue recognition along with other mundane tasks you likely deal with every day. You're not beholden to quarterly or annual reporting periods. You can pull reports anytime. Revolv3 also helps you build your company with a focus on approvals and customer retention. Learn about the Revolv3 difference today.

Disclaimer: Nothing in this article constitutes professional and/or financial or accounting advice, nor does any of the information constitute a comprehensive or complete statement of the matters discussed. Readers should use this information to consult with their accounting professionals.

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