As a business owner, you’re intimately familiar with sales. But when, specifically, does a sale occur? Is it when you receive cash or when a customer payment hits your bank account?
Or, is it when you deliver an item, perform a service, or when the customer receives your invoice?
Recognizing revenue is not just posting the money that flows in. Various factors must be considered, and specific events must occur.
Fortunately, accounting rules spell out when to record revenue, and this article covers the details.
What is revenue recognition?
Revenue recognition is a set of accrual accounting rules (we’ll discuss what accrual accounting is later) that define when a company can record a sale as revenue. These rules ensure companies report their earnings accurately and consistently.
The key considerations to recognize revenue are:
- Timing
- Performance obligations
- Transfer of control
- Measurement
How revenue recognition works
Revenue recognition depends on how a business maintains its accounting records
Businesses manage their finances using two methods: cash and accrual. What qualifies as revenue using one method may not qualify using the other.
Depending on the size of your ecommerce business, one method may work better than the other.
Smaller companies without inventory tend to use cash accounting because it’s intuitive and uncomplicated. But accrual accounting is the standard for most businesses, particularly those with large inventories, recurring revenue, and more than $500,000 in annual revenue.
Cash accounting
Cash accounting is when businesses record financial transactions only when cash exchanges hands. It’s like managing personal finances: tracking money in and money out.
For revenue recognition, cash accounting requires businesses to record sales when cash is received from their customer.
Assume you operate an ecommerce store selling footwear and you sell (and deliver) shoes worth $5,000 on December 31. But your customer pays you on January 3. Using cash accounting, you’ll record the $5,000 of revenue on January 3, not December 31.
Although cash accounting is fairly straightforward, it has limitations. For instance, cash accounting doesn't capture a company’s liabilities (what it owes to others) and receivables (what others owe it), making it difficult to get a complete and accurate picture of a business’s financial health.
This is where accrual accounting is useful.
Accrual accounting
If you’re not using the cash method of accounting, you’re using the accrual method.
Accrual accounting is when a business records revenue when it earns it, which might not be the same time it receives payment. Expenses are recorded when incurred, not necessarily when payment is made.
With accrual accounting, your attention shifts from the movement of cash to identifying the point at which income is earned and costs are incurred. For example, is income earned when you receive cash, deliver a good, receive an order for an item, or issue an invoice?
According to best practices, under the accrual method, revenue is earned at the point a customer is contractually obligated to pay for a product or service.
In a sales transaction, the point a customer must pay for a product or service is when the item ships or when the service is provided.
Assume a footwear ecommerce store receives an order from a customer named Olivia for a pair of shoes worth $500. Olivia is obligated to pay for the shoes when they ship, not when she submits the order. The moment the shoes leave the store's warehouse, the footwear company should record the $500 as sales in its books, even if Olivia doesn’t immediately pay for the shoes.
The other key thing with the accrual method is that revenues should be recognized in the same period a business incurs the related costs.
Consider how a subscription-based cosmetics company would record revenue. Assume a customer pays upfront for a one year subscription, with subscription boxes received each month. The business can’t recognize the entire payment when it’s received. Instead, it should match the revenue as it incurs the costs of providing the subscription boxes.
So if the business charges $100 per month for its cosmetics boxes, and a customer pays $1,200 for one year on October 1, the business records only $100 as revenue for October to match the costs of the cosmetic box sent to the customer. It continues to record $100 each month as revenue for the next 11 months.
It’s important to note that the IRS requires companies to earn more than $25 million in average annual revenue and publicly traded companies use the accrual method of accounting.
International standards
Imagine an ecommerce store in Memphis using a mashup of cash and accrual methods to record revenue and keep its books. Meanwhile, another ecommerce store in Seattle records its revenues the way it sees fit. This can cause a lot of confusion if you compare the two companies’ financial results.
To avoid this freestyle approach, the accounting profession has professional boards that set rules on how financial transactions are recorded and financial statements are prepared. These rules address the revenue recognition principle.
There are two main sets of accounting rules.
- U.S. GAAP, which stands for Generally Accepted Accounting Principles
- IFRS, which stands for International Financial Reporting Standards
U.S. GAAP was created by the Financial Accounting Standards Board (FASB) and is used in the U.S.
IFRS, created by the International Accounting Standards Board (IASB), is used worldwide.
Although there are subtle differences in revenue recognition between U.S. GAAP and IFRS, they don’t substantially differ from each other. In this article, however, we’ll focus on U.S. GAAP.
The 5-step revenue recognition model
The section of U.S. GAAP that discusses revenue recognition is ASC 606. ASC stands for Accounting Standards Codification and is a shorthand way to refer to specific parts of U.S. GAAP.
ASC 606 sets out a 5-step process businesses should use for revenue recognition.
Step 1: Identify the contract with the customer
Recognizing revenue starts with a contract between the customer and the company. The contract can be written, verbal, or implied through customary business practices.
Regardless of form, a valid contract needs:
- Identifiable parties (e.g., customer and company)
- Enforceable rights and obligations for both parties
- Consideration and genuine business purpose
- Collectability
Examples of documentation that can create a valid contract include:
- Formal written contracts, like purchase orders or sales contracts
- Quotes or proposals accepted by the customer
- Email communications confirming the agreement
- Standard terms and conditions
Step 2: Identify the contract’s specific performance obligations
A contract must show what the company must do to get paid by the customer. This is known as the performance obligation.
Keep in mind that performance obligations must:
- Give customers control of the good or service
- Have distinct value to the customer; meaning it could be sold separately
- Have contractual wording of what’s included in each obligation
For a single good or service, like selling a pair of shoes for $100, the obligation is typically to deliver them to the customer.
What happens when you sell a bundled service or a series of distinct goods or services?
A bundled service, like software installation and training, can be a single obligation because the customer wouldn’t value the training without the software. Or vice versa.
If you’re selling a series of distinct goods, like a monthly cosmetics subscription box, each monthly delivery is a separate performance obligation.
Step 3: Determine the transaction price
The transaction price, the amount a business expects to be paid for performing an obligation, should be specified in the contract.
Aside from the money a business expects to be paid, the transaction price should include non-cash items like discounts, credits, and barter arrangements to reflect the total the company expects to collect.
Although determining the transaction can be straightforward, many times that is not always the case.
What happens if the contract allows the customer to ask for a refund?
When the transaction price can be variable, like with refund clauses or performance goals, the company needs to determine the likelihood of the variable happening and the magnitude, in dollar amount, if the variable occurs.
Step 4: Allocate the transaction price to distinct performance obligations
ASC 606 requires businesses to allocate the total transaction price to each performance obligation “based on the relative standalone selling price of the goods or services underlying each performance obligation.” This allocation is important because it determines how much revenue to recognize with each obligation.
Allocating the transaction price is straightforward when there is only one good or service sold.
But what happens when a bundle of items are sold for a set price?
When more than one item is sold in a bundle, a company can allocate the transaction price using:
- Stand-alone selling price: Assumes that each obligation can be sold separately to the customer at fair market value.
- Proportional method: Used when defining a fair market value for an obligation is impractical. Instead, the transaction price is divided proportionately based on the relative size of the obligation compared to others.
Let’s review an example to see how this works in practice.
Assume a software developer designs and implements a custom CRM for a customer. The developer designs, implements, and trains the customer’s employees on the new software.
The contract is for $70,000 and is broken down into:
- $40,000 for design and coding
- $20,000 for implementation
- $10,000 for training
If we assume the fair market value of each obligation is the same as the contract breakdown shown above, the developer would record revenue:
- $40,000 upon completion of the design and coding
- $20,000 upon successful implementation
- $10,000 upon completion of employee training
But if the fair market value for each obligation is difficult to calculate (which is likely the case in this example), the developer would use the proportional method.
- Phase 1: Design and coding - most complex, resource intensive, and highest value for the customer
- Phase 2: Implementation - less complex but necessary for using the software
- Phase 3: Training - least complex but adds value for the customer
Using the developer’s calculated complexity-to-value ratio, it decides on a proportional allocation:
- Phase 1: 70%
- Phase 2: 20%
- Phase 3: 10%
Revenue recognition under the proportion method would be:
- Completion of phase 1: 70% x $70,000 = $49,000
- Completion of phase 2: 20% x $70,000 = $14,000
- Completion of phase 3: 10% x $70,000 = $7,000
Step 5: Recognize revenue when you fulfill each performance obligation
The last step in the revenue recognition process requires companies to record revenue in their financial records when each performance obligation is completed.
Types of revenue recognition
The following are some common types of revenue recognition.
Digital subscriptions (SaaS)
Businesses like Netflix or software providers, where customers sign up for a service for a specified period, should recognize revenue on a straight-line basis where an equal portion of revenue is recognized for each period the customer has access to the service.
Physical subscriptions
If you offer a subscription for a physical item like a magazine or gift box, revenue is recognized when the item is delivered to the customer.
Ecommerce
Ecommerce stores should recognize revenue when they ship products.
Installments
Businesses offering installment payment options should recognize revenue when they deliver the product or provide the service.
Digital goods and products
Companies selling digital goods and services that are downloadable, including e-books and movies, should recognize revenue when clients download the digital products.
How Shopify helps with revenue recognition
Shopify helps businesses with revenue recognition in three ways.
- Taxes: Businesses collecting sales tax can set Shopify to automatically handle the most common sales tax calculations.
- Detailed sales analytics: Businesses can use Shopify's analytics to glean deeper insights into their sales and customers to design relevant marketing strategies for future sales goals.
- Facilitating returns and exchanges: Thanks to Shopify Admin, businesses can easily refund orders, create returns, and add exchange items for customers.
Revenue recognition FAQ
What are the 5 criteria for revenue recognition?
The five criteria of revenue recognition is a ladder-like procedure and include:
- Identifying the contract with the customer
- Identifying separate performance obligations
- Determining the transaction price
- Allocating the transaction price to the various performance obligations
- Recognizing revenue in the books of accounts.
What is the GAAP rule for revenue recognition?
According to U.S. GAAP, revenue is recognized when a good or service is transferred to a customer, and the amount recognized reflects the expected payment from the customer.
Can you recognize revenue before invoicing?
Yes, you can recognize revenue before you invoice a customer. Revenue is recognized when you satisfy your performance duties under a contract and that may happen before you get around to invoicing your customer.
