In theory, revenue recognition seems pretty straightforward: Income is recorded once earned via the sale of goods or services, regardless of when the payment is received. The reality, though, is that varying business models, complex contractual terms, collection uncertainties, multiple deliverables, lengthy projects, and more can quickly muddy the waters, making it hard for a company to know exactly how to recognize revenue. And yet, it must be done right so investors and other stakeholders can count on transparent and accurate financial reporting across industries.
This article explores the various types of revenue recognition and dives into the different revenue recognition methods businesses use. It also explains how to pick the method that will work best for your particular company so you can move forward in confidence.
Different Types of Revenue Recognition
As we mentioned above, revenue recognition isn’t always cut and dry. A variety of factors can impact when and how revenue should be realized. Below, we discuss different types of revenue recognition and examine how the process can vary between industries.
Point in Time vs. Over Time
Revenue can be recognized at a specific time or over a period.
In general, revenue is recognized at a point in time when a specific event occurs, such as the delivery of a product or the completion of a service, signaling the transfer of ownership and making the transaction complete. For example, this method is often used in the retail industry when the transfer of ownership is done at the time of the sale. Think about buying a sweater at H&M; you receive ownership of the sweater the moment you pay for the sweater in the store and the sale is made. When revenue is recognized over time, on the other hand, it is spread across the duration of a longer-term contract or service period. This type of revenue recognition is often used in the construction, utilities, consulting, and software-as-a-service (SaaS) industries.
SaaS revenue recognition, for instance, occurs gradually as the service is provided over the subscription period. Revenue is matched to the periods in which it’s earned, reflecting the ongoing nature of the service.
The distinction between point in time and over time lies in the nature of the deliverable—instantaneous or continuous—which then dictates the best method for recognizing revenue.
Sale of Goods vs. Rendering of Services
Revenue recognition is also impacted by whether the business sells a physical product or an intangible service.
When there is a sale of goods, a company recognizes revenue at the point of transfer of ownership (in other words, once it fulfills its performance obligation per the contract). This is often upon delivery or when the risks and rewards of ownership are transferred to the buyer. Moreover, at this point, the seller is reasonably assured they can collect payment for the goods sold.
Conversely, a company that renders services will follow different principles when recognizing revenue on its financial statements. In this case, revenue recognition occurs once the services have been completed or are performed over time, depending on the nature of the service agreement. The company’s accounting team must identify the completion stage, assess the level of fulfillment of the services, and proportionally recognize revenue as the service progresses.
Unlike the sale of goods, revenue recognition in service delivery can be complex and contingent on milestones or the satisfaction of specific performance obligations over time.
Specific Industries and Revenue Recognition
How and when revenue is recognized can vary widely depending on a company’s business model and industry.
For example, in construction, where long-term contracts are standard, revenue recognition often hinges on the percentage-of-completion method, which reflects project progression. Milestones and costs play a significant role in determining when and how much revenue can be realized.
Meanwhile, as software and subscription-based businesses strive to adhere to the ASC 606 revenue recognition standard, they must factor in elements like evolving subscription terms, bundled services, usage, and service delivery—all of which can quickly and dramatically complicate the process of recognizing revenue.
Retail and eCommerce companies typically use point-of-sale recognition, acknowledging revenue upon product delivery to the customer, with considerations for returns and refunds.
In the media and telecommunications industries, on the other hand, revenue recognition is often impacted by the offering of bundled services, necessitating allocation across the offerings. To accurately recognize revenue, these companies must understand usage patterns, licensing, and service duration.
Across these sectors, different contract types, service setups, customer usage, and delivery options influence revenue recognition practices, demanding tailored approaches for each industry.
Revenue Recognition Methods
Next, let’s investigate several revenue recognition methods beyond the common sales basis method (when revenue is recognized at the time of the sale or when a performance obligation is fulfilled). Even though each revenue recognition method mentioned below abides by the ASC 606 framework, they all provide different ways for companies to recognize revenue based on their particular needs and circumstances.
Completed Contract Method
The completed contract method is usually used when the outcome of a contract can’t be reasonably estimated until it’s completed. In this instance, all revenue and costs are recognized at the project’s conclusion rather than incrementally as the work progresses.
This method can be useful for short- or long-term projects lacking progress indicators. However, it might not be the best revenue recognition method if your company provides its customers with an extended warranty or a long return period.
Example: Picture a small event planning company like Party Perfect or a graphic design firm like 99designs. These businesses often use the completed contract method. They wait until the entire project – the party or the logo design – is finished before counting the money they’ve made.
Percentage of Completion Method
On the flip side, the percentage of completion method recognizes revenue proportionately to the project’s completion, reflecting the revenue earned based on the percentage of work done against the total project estimate. A company might use this method when its long-term project’s percentage of total work completed is measurable and reliably indicates its progress.
This method is commonly used in the commercial construction industry.
Example: For a construction example, consider big players like Bechtel. They use the percentage of completion method. As they hit pre-determined percentages of project completion in massive projects, they acknowledge the money they’ve earned. Consulting firms like McKinsey may also use this method, recognizing revenue as they complete different stages of a project.
Installment Sales Method
The installment method, meanwhile, is used to recognize revenue when cash is received in multiple installments over an extended period for goods or services delivered. The related costs are known in this scenario, but the full payment often isn’t guaranteed.
For example, a real estate company whose buyer makes periodic payments over several years would use this method to recognize revenue as payments are received.
Example: Consider a real estate developer like D.R. Horton, selling houses through installment plans. When the home buyer chooses not to take out a mortgage, but rather, pay in installments to the home seller or builder. High-end machinery manufacturers like Caterpillar might also use the installment method, especially when dealing with large industrial equipment. These companies recognize revenue as customers make payments over time.
Cost Recovery Method
Then, there’s the cost recovery method, typically used for revenue recognition when it’s impossible to know or estimate the cost of the goods or services required to honor the contract. Some of its limited use cases include companies that frequently experience payment delays and those that sell their products on credit.
Example: Imagine a startup getting custom software from a developer. If the developer is unsure about payment, they might use the cost-recovery method. In this scenario, it’s like saying a small software development company is waiting to count the money they made until they’ve covered all the costs. An example could be a local developer working with a startup company.
Milestone-Based Method
Finally, when it’s uncertain whether a company can meet specific project goals, it might employ the milestone-based method. As the name implies, revenue is recognized as milestones are achieved, with each milestone representing a significant event or stage in the project that justifies recognizing a portion of the total revenue.
Other revenue recognition methods beyond those listed above include accrual, brokerage agreement, appreciation, proportional performance, deposit, and transactions under bill and hold.
How to Decide What Type of Revenue Recognition Is Best for You
A good way to identify your company’s best revenue recognition method is by conducting a thorough, strategic evaluation. Right off the bat, you’ll need to consider your company’s business model and ensure whichever method you choose adheres to regulatory guidelines. Remember, the financial statements of a company display its financial health, and revenue recognition significantly impacts these.
As you know from above, each revenue recognition method has intricacies that must be examined and fully understood. They all, however, comply with the ASC 606 guidelines issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).
ASC 606 aligns with Generally Accepted Accounting Principles (GAAP), such as the revenue recognition principle. These standards emphasize the importance of recognizing revenue when it’s earned and realizable, irrespective of cash flow, helping to ensure accurate and consistent financial reporting.
After investigating each method, assess the nature of your transactions, customer contracts, and service offerings. Companies with long-term projects, for example, might benefit from the percentage of completion method, where revenue is recognized based on the project’s completion stage.
For those dealing with goods, the point of sale or sales basis method, recognizing revenue when products are delivered, might be a better choice. There is a fit out there for every type of company.
It’s also important to pay attention to the concept of performance obligations, derived from the FASB and IASB guidelines, which are promises in a contract to transfer goods or services. Understanding your obligations helps determine when revenue should be recognized—whether at a specific point in time or over a period. This also impacts the method you should use to recognize revenue (for instance, realizing revenue upon completion of an individual performance obligation or proportionally as obligations are met over time).
Ultimately, choosing a revenue recognition method should be a thoughtful process that factors in all the nuances of your business operations, regulatory standards, and the nature of your revenue-generating activities. It can be valuable to consult with other accounting professionals and explore recurring revenue management software options as you make this crucial decision.
It’s Essential to Choose the Right Revenue Recognition Method for Your Business
You’re not alone if you feel intimidated by the prospect of selecting a revenue recognition method for your business—especially if its business model introduces several complexities. Talk about a daunting decision!
As you can see from above, there are many revenue recognition methods to consider, from installment and milestone-based to percentage of completion. Some are better in certain situations than others.
With revenue recognition at the heart of financial reporting transparency and accuracy, your business simply has to nail this decision or risk alienating investors and other stakeholders. Moreover, it’s critical you select a recognition method that will keep your company in compliance with all the regulatory requirements that exist these days.
So, what do you do? This is where RightRev steps in.
How RightRev Can Help
Figuring out which revenue recognition method to use is hard enough. Then comes the challenge of all the manual calculations, figured out on spreadsheet after spreadsheet, that take up precious hours of your accounting team’s time.
RightRev can relieve you of all this stress, providing a one-stop revenue recognition software solution that’s flexible, scalable, accurate, and fully compliant.
Check us out today!
