Revenue is at the heart of all business performance. Everything that you do as a small business owner or entrepreneur hinges on closing the next sale. It doesn’t matter what career path or industry you choose to work in. You work hard to close the deal, send that invoice, and make money! But, have you ever thought about when revenue recognition occurs?
In layman’s terms, revenue recognition is a generally accepted accounting principle (GAAP) that standardizes how and when businesses globally realize a sale—and ultimately, revenue.
If you’re a freelance developer, you might charge your client a lump sum amount for a web development project. Pay 50% upfront and the rest upon completion. If you’re a freelance designer, you might present a monthly invoice and work on a fixed retainer on a month-by-month basis.
In these scenarios, do you recognize revenue at the time of invoice (when your services are performed and completed), or do you realize revenue at the time of payment, say 15 days later?
That’s where revenue recognition comes in.
What is revenue recognition and why is it important?
A feature of accrual accounting, revenue recognition is an accounting principle of ASC 606. It mandates that revenue is recognized when the delivery of promised goods or services matches the amount expected by the company in exchange for the goods or services.
Basically, any realized goods or services received by a customer (but payment is expected to come later) are recognized as revenue for your business.
Some of the top benefits of accrual accounting (which defines revenue recognition) are:
- Simpler taxes — because business owners can issue invoices at the start and end of the year, accrual accounting actually helps reduce tax burden
- Improves planning and forecasting — business owners get a much clearer picture of how well the business is performing because they don’t have to wait around for a cash transaction
- Investors prefer this accounting method — in an investor’s eyes, a business that uses accrual accounting over cash accounting is viewed as a more established business. Why? Like the first point, investors see a more accurate financial picture because this method reflects all sales that have been shipped as well as liabilities that have not yet been paid
By creating an industry-neutral accounting standard, it’s far clearer to make an apples-to-apples comparison of each company’s revenue, line by line on an income statement.