What Is Revenue Recognition, and Why Does it Matter in Sales?

Don't count your chickens before they're hatched. That, in an (egg)shell, is revenue recognition. So, before you start seeing dollar signs after closing that big sale, let's dive into the accounting rules that will keep your financial statements in line — and keep Uncle Sam happy.

What you'll learn:

• What is revenue recognition?
• Revenue recognition steps and standards
• Types of revenue recognition
• Benefits of effective revenue recognition
• How to choose the right CRM

Revenue recognition is the process that dictates when revenue can be recorded based on when the service is delivered — and not when the cash is collected from the company. The revenue recognition principle is a generally accepted accounting principle (GAAP) that identifies the specific conditions under which revenue is considered to be earned.

A real-life example of revenue recognition would be Farmer Joe buying a tractor from a farm supply store in January 2024. The tractor is sold to Farmer Joe for $8,900, so the payment of $8,900 is recognized by the farm supply store as revenue for the month of January 2024.

But the farm store supply salesperson convinces Farmer Joe to get an annual service contract for $120. Even though the farm store supply company collected the $120 from Farmer Joe upfront, they have to recognize the revenue when they actually deliver the service. Since Farmer Joe entered into an annual service contract with the farm store supply company, the money has to be spread out over 12 months — you can't recognize that $120 immediately. You may have the cash, but you haven't rendered the services. That means it's revenue that is not recognized.

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To eliminate discrepancies in how businesses handle accounting for similar transactions across various industries, the Accounting Standards Codification (ASC) defined standardized accounting principles for revenue recognition with ASC 606.

ASC 606 was developed by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) and went into effect in 2018. All businesses that engage in contracts with customers must comply with these standards.

ASC 606 outlined a five-step process for recognizing revenue from contracts with customers:

1. Identify the contract with the customer: Before entering into a contract with a customer to supply products or services, review the agreement between the parties, the rights and payment terms, and the process of collecting the debt.
2. Identify performance obligations: Once a contract is identified, analyze the nature of the promised products or services — and determine whether they are distinct and should be accounted for separately. A product or service is considered distinct when it is of value to the customer and can stand alone and be transferred independently of the other products or services in the contract.
3. Determine the transaction price: This involves assessing what is expected in exchange for transferring products or services to the customer. Consider whether the products or services will be paid over time, by credit card, in cash, or through barter. Factor in any discounts, prorations, upgrades, or pricing customizations.
4. Allocate the transaction price: Once the transaction price is determined, it needs to be allocated to each performance obligation within the contract.
5. Recognize revenue: Finally, revenue is recognized when the control of the promised products or services is transferred to the customer.

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Different types of revenue recognition methods are used depending on the nature of the business and the transaction. Here are some of the most common types:

• Accrual basis: Revenue is recognized when the control of goods has transferred to the buyer.
• Cash basis: Revenue is recognized only when cash is received.
• Sales of services: Revenue is recognized over time as the service is performed. For example, a farm supply store recognizes revenue monthly as it provides services to Farmer Joe.
• Percentage of completion: Used for long-term contracts, such as construction projects. Revenue is recognized based on the percentage of work completed during the period. This method matches revenue with the expenses incurred to earn that revenue.
• Completed contract: Revenue is recognized only when a contract is completed. This method is often used in industries where the outcome of a contract cannot be estimated reliably. Some examples include construction, where there are often unforeseen expenses; film and television production, where costs can frequently go over budget; and research and development in the pharmaceutical industry, where there may be unexpected regulatory hurdles.
• Installment sales: Revenue is recognized as cash payments are received, usually over a period of time. This is common in industries such as real estate, where the sale of a large asset may be paid for in installments.
• Cost recovery: Revenue is recognized only when the cost of the goods sold has been recovered. This method is conservative and used in situations where there is a high level of uncertainty about being able to collect.
• Subscription model: Revenue is recognized over the term of the subscription as the service is provided. For example, a software as a service (SaaS) company would recognize revenue monthly, quarterly, or annually as customers use the service.
• Milestone: Revenue is recognized when specific milestones are achieved in a contract. This is often used in industries such as pharmaceuticals or engineering, where payment is tied to achieving specific project milestones.
• Proportional performance: Similar to the percentage of completion method, this approach recognizes revenue based on the proportion of the total contract that has been performed. It's often used in service contracts where the work is spread evenly over the term of the contract.
• Unit of delivery: Revenue is recognized as each unit is delivered to the customer. This method is useful for contracts where goods or services are delivered in separate installments.

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Even though the cash may not technically be in your coffers right away, properly recognizing and knowing how to calculate recurring revenue offers several clear benefits:

• Accurate financial reporting: Keep your accountant on point — proper revenue recognition in financial statements more accurately reflects a company's financial performance.
• Compliance: Accounting standards such as GAAP and International Financial Reporting Standards (IFRS) mandate accurate reporting of recurring revenue for legal compliance and regulatory purposes.
• Investor confidence: When revenue is recognized accurately and transparently, it builds trust with investors — and those investors can be confident that the company's financial health is being reported honestly.
• Improved decision-making: Accurate revenue recognition helps management make better decisions about budgeting, forecasting, and strategic planning.
• Consistency: Standardized revenue recognition practices allow for consistency across reporting periods. This makes it easier to evaluate a company's performance over time.
• Risk management: Proper revenue recognition helps identify and mitigate potential risks, such as recognizing revenue too early — or too late, which can lead to distorted financial statements.
• Enhanced credibility: Accurate and reliable revenue recognition practices improve a company's credibility with creditors, as it demonstrates responsible financial management and reduces the risk of default on loans.
• Tax compliance: Correct revenue recognition ensures a company reports income accurately for tax purposes, avoiding potential legal issues or penalties from the IRS.

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To recognize revenue properly, you need a customer relationship management (CRM) platform that aligns with your company's accounting practices, compliance requirements, and business needs.

First, determine the specific revenue recognition rules your company follows, whether GAAP, IFRS, or another standard. Depending on your industry, see whether the CRM platform supports subscription billing, milestone-based revenue, or multi-element arrangements, and can generate reports.

You don't want headaches when integrating a new CRM platform. Make sure it works seamlessly with your accounting software or Enterprise Resource Planning (ERP) system. This integration is critical for automating revenue recognition processes and ensuring data consistency across platforms. Look for CRM systems that provide real-time data synchronization among sales, finance, and operations teams, allowing for accurate and timely revenue reporting.

Automation makes life easier. Choose a CRM platform that offers automation capabilities for revenue recognition tasks such as invoicing, contract management, and tracking deferred revenue. Make sure the CRM allows customization of revenue recognition rules and workflows to match your company's business model.

Well-run revenue operations — or RevOps — is an essential framework for a company's growth. A CRM platform that can scale with your company helps achieve that goal. Look for a CRM platform that offers advanced features, additional users, and support for complex revenue streams. A scalable CRM platform typically offers modular features that you can add as your revenue recognition needs evolve.

The CRM platform should be user friendly, with an intuitive interface that minimizes the learning curve for your team. Consider the availability of training resources and customer support to ensure your team can effectively use the system for revenue recognition tasks.

Look for a CRM platform that provides robust reporting and analytics tools. It should be able to generate detailed revenue reports, track performance against targets, and forecast future revenue. The ability to create custom reports tailored to your specific revenue recognition needs is a significant advantage. You can also use AI to find revenue when you have the right tools.

Ensure the CRM platform has strong security measures to protect sensitive financial data, including encryption, access controls, and regular security audits. Verify that the CRM platform complies with relevant regulations, such as GDPR for data protection, and supports audit trails for revenue recognition processes.

Finally, make sure the CRM platform provides ongoing support, including regular updates to keep the system in line with changing accounting standards and business requirements.

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Revenue recognition isn't just an accounting concept — it's essential for financial accuracy and transparency. By adhering to standardized principles such as ASC 606, businesses can ensure their revenue reporting is consistent, reliable, and compliant. With a CRM platform and accounting practices in place, companies can build trust with investors, make informed decisions, and ultimately drive growth.