Earning revenue has always been exciting and enthralling for businesses, but its recognition turns out to be challenging at times. This was intensified when the process of recognizing revenue underwent a significant revolution. Businesses typically used to record revenue when a sale was made, and money was received; however, this is against the accounting rules because receiving revenue and earning revenue are two very different things.
Revenue recognition becomes even more complex in SaaS businesses due to their operational reliance on subscription-based business models, which in turn follow either a plan-based approach, a usage-based approach, or both.
The Financial Accounting Standards Board (FASB) significantly revolutionized and offered a new perspective on how revenue should be recognized with the publication of Accounting Standards Codification (ASC) 606 as a part of Generally Accepted Accounting Principles (GAAP) in the U.S. in 2014. Following the same, the International Accounting Standards Board (IASB), as a component of the International Financial Reporting Standards (IFRS), issued guidelines on considering the revenue generated and when to amend correct financial accounts.
In this article, we will explore what revenue recognition is, how ASC 606 affects it, and the five processes that ASC 606 specifies that must be followed to recognize revenue successfully.
Revenue recognition is an accounting principal for recognizing and reporting revenue in a company's financial statements. Revenue, a crucial concept in accounting and financial reporting intended to provide transparency and consistency in accounting practices, must only be recognized after certain critical components occur.
Recognizing revenue can take several forms dependent on the business type, the goods or services offered, and the terms of the sale. In general, revenue recognition entails identifying the source of revenue, calculating the amount of revenue generated, and documenting that revenue in the company's financial statements. In contrast to the fact that revenue from the sale of products is often recognized when the products are delivered to the client, income from the provision of services may be recognized over time as the services are rendered.
One of the key challenges in revenue recognition is determining the right time to recognize revenue, which is the fundamental issue we highlighted at the very start. The process is particularly complex when transactions involve multiple elements, high volume transactions, plan revisions (upgrades or downgrades), discounts or coupons offered, or income accrued over time. Accounting standards codification came to the aid to address these challenges offering instructions on when and how to recognize revenue.
A new revenue recognition standard surfaced in May 2014, which signified the close relationship between revenue recognition and ASC 606. For businesses to recognize revenue, it lays forth a five-step procedure that they must adhere to.
Following the principles outlined in ASC 606, companies must recognize revenue whenever control of a good or service is given to a customer, which might happen before or after the revenue is received. Maintaining the integrity of financial statements and ensuring investors have access to the data they need to make informed investment decisions depend on accurate and consistent revenue recognition methods.
The five steps to recognize revenue involves the identification of a contract with a customer, the identification of separate performance obligations, the determination of the transaction price, the allocation of the transaction price to separate performance obligations, and the recognition of revenue when (or as) performance obligations are satisfied. Let us discuss each in detail.
A contract is an agreement between two or more parties that establishes enforceable rights and duties, as stated in the first step of ASC 606. For a customer contract to be recognized under the standard conditions, certain criteria are required to be met.
Per the standards, a customer contract is identified when it meets five specific criteria.
- Both parties involved in the transaction must approve an identified contract.
- The rights and obligations of each party must be identified and clearly defined in the contract.
- The contract's payment terms, including the amount of consideration expected to be received, must be identified, and clearly stated in the contract.
- It must be probable that the compensation will be collected in exchange for the goods or services provided.
- The contract must have commercial substance, meaning that the contract's risks, benefits, and obligations are expected to change due to the transaction.
Identifying the contract's performance responsibilities is the second phase of the Financial Accounting Standards Board's (FASB's) ASC 606, which governs revenue recognition. A commitment to a customer in a contract to transfer a certain good or service to the client is a performance obligation.
The core principle in the ASC 606 revenue recognition standard directs how businesses should account for revenue from client contracts. This covers subscription, implementation, hardware, training, and other professional services for SaaS businesses because not all obligations are always set up in CRM systems.
According to ASC 606, businesses must list all their performance commitments in a contract and divide the transaction price among them according to how much each of those commitments would sell for on their own. Doing this ensures that revenue is only recognized when the performance requirements are met, which usually happens when the client takes possession of the promised goods or services. To demonstrate, imagine that any service offered to subscribers for free isn't included in CRM systems, necessitating human tracking deals to allocate funds to different performance expectations, which can be tiresome.
The amount of compensation a business anticipates receiving in exchange for offering goods or services to a client during the contract is calculated as the transaction price. Calculating the transaction price is challenging since the ultimate price is affected by variable and non-variable contract elements, including discounts, rebates, refunds, performance bonuses, and other factors.
Proper transaction pricing determination ensures precise and reliable revenue recognition throughout the contract. Businesses must additionally alter the transaction price to account for the effects of the time value of money and any non-cash consideration. Yet, automation may make life easier while guaranteeing that every transaction accurately reflects your recognized income.
SaaS enterprises promote repeated product delivery through subscriptions rather than operating like businesses relying on a single transaction. By spreading the agreement cost across the entire subscription period, it generates what was once referred to as continuous performance obligations.
The standalone selling prices of each performance obligation, such as integration services, training, or equipment that must be valued independently and recognized, must be determined before companies may assign the transaction price. Companies can allocate the transaction price to each performance obligation based on their relative selling prices once the standalone selling prices have been established. If observable prices are available, they can use them; if not, they can approximate standalone selling prices.
When done manually, the procedure expands significantly and exponentially as sales rise. Automating this procedure of allocating transaction prices to performance obligations based on predetermined criteria sent in an SSP Library speeds up the process.
The performance obligation is considered satisfied when the customer takes possession of the promised good or service in a timely manner or over the course of time, which determines when revenue is recognized.
Handling financial reporting manually increases the risk of errors throughout the revenue recognition process since it might take a lot of work to calculate when anticipating delivery dates or calculating progress to completion. Making estimates for the future requires figures to be accurate.
Given the difficulties associated with this business model, SaaS-based companies may find manual revenue recognition administration time-consuming, laborious, and expensive. To assure end-to-end revenue recognition, only a software solution is needed.
ASC 606's fifth step can help businesses ensure revenue is recognized accurately and per the standard's guiding principles. For accurate financial reporting and analysis, this step is essential. Businesses must consider the contract's terms, the type of products or services being transferred, and the anticipated timing and pattern of transfers when deciding whether to recognize revenue.
Following ASC 606 steps to recognize revenue is crucial to determine whether you have earned that revenue. A wide variety of revenue recognition software is available to automate the revenue recognition process, which only needs to comply with ASC 606.
So, unburden your finance team from tedious duties with Billsby. We have automated revenue recognition reporting built into our subscription billing software, to keep you on top of your ASC 606 requirements.