Revenue Recognition Method: What do Small Business Owners Need to Know?

Working with big orders comes with their own set of complexities from the accounting point of view. To be more specific, such large deals don’t always translate to on-the-spot cash realizations or sometimes the cash is realized in advance for services or goods that are yet to be delivered to the client. This leads to the question – when should the revenue recognized?

In this blog, we are going to discuss the concept of the revenue recognition method and how, as a small business owner, you can follow this principle.

It is very common to observe a delay or early realization of payments that leads to deferred and accrued revenue which in turn puts pressure on the accounts team to follow the bookkeeping process with utmost accuracy and due diligence.

Also, according to Generally Accepted Accounting Principles (GAAP), revenue recognition plays a very significant part in the accrual accounting system by maintaining the accuracy of your balance sheet and financial reports.

Difference Between Cash and Revenue

Before we address the revenue recognition concept, we must first clarify how cash is different from revenue and how cash earnings don’t always translate to revenue recognition. A lot of small businesses are not aware of the fact that these two do not always mean the same.

Let’s assume you own a stationery company where you deliver goods to your customers on the spot. In this scenario, you can easily consider your cash earned as recognized revenue.

But if you were a SaaS company where customers pay you upfront for annual subscriptions, you can’t assume the lumpsum annual fee as recognized revenue, yet. The key difference over here is that you are yet to render your service for the entire year to your customer, and also, the customer may back out midway through the year and ask for a refund. Which in turn has implications for your cash flow projections. We will explain both of these examples at the end of the blog to give you a better idea.

What is Revenue Recognition?

Revenue recognition is a GAAP concept that asserts that revenue must be recognized as it is earned. The stress over here is on the part where revenue is recognized only when goods and services are delivered to the customers as opposed to when the payment is made to the vendor.

For example: Consider the earlier shared stationery company example again. You have received an advance payment of $1000 from a customer for office supplies in the third week of May. But you made the delivery to the customer in the month of June.

Your company ledger in May would look like this when you receive the payment in advance.

You would have to register $1000 as credited in the client pre-payment account and, at the same time, $1000 debited from your income account. This is also referred to as deferred revenue.

As we had pointed out earlier, revenue recognition is centered around the fact that revenue can only be recognized if you have rendered your service or delivered your goods to your customers.

So, in the month of June, your company ledger would look like this.

Lastly, we will conclude this blog by discussing two different types of businesses that manage their revenue recognition process in a very different way.

Example 1: Software as a Service (SaaS) company in digital marketing space

In the first scenario, we will consider software as a service provider company, where the customer has already paid for the entire year's subscription of $1000 in the month of Jan.

As you can see here, the company’s ledger reflects the revenue recognized in a month-wise manner. This is to prevent the company from burning through their cash and be in a position to refund customers who stop their service midway.

Example 2 Stationery Company  

In the second scenario, we have a stationery company that has received the payment for office supplies upfront. The customer had committed to paying for the office supplies in the month of April and followed that up with an actual payment in the month of May. However, the stationery company could only deliver the office supplies in the month of Jun. Which in turn reflects in the company ledger as recognized revenue.

Revenue Recognition: The Key to Financial Success

Even though the original intention behind building ASC 606 was to standardize and bring clarity into the overall revenue recognition process. However, one of the key benefits that business owners can leverage is that they can easily convince external entities like investors and analysts that their business follows a well-defined transparent process that instills confidence into their business ethics and robust accounting practices.