Revenue Recognition 101

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What is Revenue Recognition?

Is it the corporate version of the old rhyme, “See a penny, pick it up”? Unfortunately, not. It’s much more complicated than that, and it’s getting even more complicated with the new revenue recognition standards.

In this guide, we’ll help you understand the key aspects of revenue recognition, the new GAAP principles, what they mean for your business, and how automation can help you recognize revenue more efficiently and accurately.

Key Aspects of Revenue Recognition

Revenue is the income that a business receives as a result of its activities (from selling products and/or services). There are three types of revenue a company may receive as a result of its business activities: sales revenue, incidental revenue, and non-operating revenue.

  • Sales Revenue: Revenue generated from primary business activities. For example, revenue generated as a result of a company selling products and/or services to customers.
  • Incidental Revenue: Revenue, often in small or insignificant amounts, received in the course of performing business activities but not generated through primary business activities. For example, interest earned on deposits in a demand account.
  • Non-operating Revenue: Revenue received from peripheral, or non-core, operations. For example, rent received by renting out a portion of a company’s office space.

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Generally Accepted Accounting Principles (GAAP)

According to the Revenue Recognition Principle, as outlined by the Generally Accepted Accounting Principles (GAAP) guidance, revenue must be recognized when realized or realizable and earned.

This basically means revenue is recognized when it’s realized or earned, irrespective of when the cash comes in. Recognizing the revenue means recording the amount of ‘consideration’ as ‘earned’  in a company’s financial statements. It’s the process by which companies identify ‘when’ and ‘how much’ (expected) is to be recorded as earned or recognized revenue. Revenue is earned when a company has delivered the product(s) and/or performed the services, and met all criteria for revenue recognition as outlined by the GAAP guidance.

Now, a customer may pre-pay or post-pay for a product and/or service or pay at the point of sale. However, the company must recognize the payment (pre-payment, post-payment or point of sale payment) at the point in time when the company satisfies the terms of the sales contract and the ‘value’ of the deal is delivered or transferred to the customer.

As an example, let’s say your company builds widgets –

  • This company receives $100 of consideration (or pre-payment) from a customer for a yet-to-be-built widget. This $100 pre-payment goes into your company’s bank account.
  • Your company hasn’t delivered the widget to the customer yet, so the firm hasn’t ‘earned’ the consideration, or revenue, from the sale of the widget.
  • Using accrual accounting (in which timing for the recognition of income doesn’t coincide with the timing of receipt and payment of cash), the company must account for that $100 pre-payment as deferred revenue.
  • Now, in building this widget and shipping it to the customer, your company has costs equating to $50, which are accounted for under deferred expenses.
  • At the point in time when the company satisfies the terms of the sales order, which in this example happens when the company delivers the widget to the customer, the company may recognize the pre-payment of $100 as recognized, or earned, revenue and may also recognize the $50 in deferred expenses as actual, or realized, expenses.

Now, imagine your company is selling millions of widgets, “widget installation” services, and a “widget warranty.” And imagine what it takes to keep track of all that revenue. This, of course, gets even more complicated when you take into account discounts and special packages. All these factors and more can affect the pricing and timing of your revenue.

How Can Automation Help You Recognize Your Revenue?

When you combine the complexities of the new revenue recognition guidance with the complexities already existing in your business, you find an increased potential for errors and financial misstatements. Reliance on spreadsheets, manual journal entries, manual account reconciliations, hard copy report distribution, decentralized document storage and version control opens up the possibilities of having several weak links in a very important chain. The reality is that financial organizations are always evolving with personnel constantly in flux.

Thankfully, with the right tool, the days of “doing it all manually” with endless spreadsheets are winding down. Leading companies are no longer willing to put the top line of their financial statements at risk and are turning to automated tools to give them increased visibility, better data for decision-making, and higher levels of confidence that they are fully compliant with all applicable standards.

Here are some of the main benefits of automating your revenue recognition:

  • An organization built around a consistent and transparent revenue automation engine establishes a set of procedures for process continuity and minimizes the risk of disruption and miscalculations.
  • Defects in upstream processes often result in bad data and additional work for the revenue accounting team to correct system-generated entries each month and quarter. Automation will help expose upstream process defects quickly and ensure you resolve them on time.
  • Creating intuitive, easy-to-use, and configurable rule sets in line with the volume and complexity of your business will help eliminate a dependence on database scripting and reporting queries to complete your revenue management processing while reducing your close process and the need for consistent IT involvement.
  • By automating revenue processing in a standard and consistent manner, you will also eliminate customization and special knowledge sets. Come audit time, the resources and effort involved will be significantly reduced while confidence in the data derived skyrockets.

In brief, investing in a good revenue automation tool will give you peace of mind and help you lessen your financial risk by establishing consistent data streams and incorporating rule-making efficiency.

Learn how Zuora RevPro can help you automate your revenue recognition and meet the new standards!

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