Understanding your books and coming up with comprehensive financial documents can be a real challenge. One of the areas where business owners are often confused pertains to recognizing their revenue. When do you add the funds to your account and financial picture? Is it when you receive the money or when the goods are delivered?
If you find yourself struggling to figure out how to recognize revenue in your business, here’s everything you need to know about the process:
What Is Revenue Recognition?
Before we can dive too deeply into how to measure and track revenue recognition, it is important to have a firm grasp on just what revenue recognition is. This term encompasses the way that any business tracks its revenue. There are two main categories that your business may fall into: Cash accounting or accrual accounting. Both have a major impact on when revenue is going to be recognized.
Under cash accounting, revenue is recognized as soon as the money hits your bank account. It doesn’t matter when the product or service is actually rendered to the customer.
On the other hand, accrual accounting focuses on when the product or service is provided to clients. Revenue will be recognized as soon as those goods or services are rendered, no matter when the cash was received.
Of course, there are also subtleties that you may have to explore if you work in certain industries. For example, project-based businesses and subscription-based businesses may have a harder time recognizing their revenue. If this describes your business, then it might be time to consider bringing in a professional accountant to guide you through the process.
Understanding when revenue recognition takes place in your business is essential to coming up with a comprehensive snapshot of your financial health as a company. It might make investors more apt to grant you the funds that you need to continue to grow. Revenue recognition is a way to track how well your business is doing in comparison to other similar companies.
Why Does Revenue Recognition Matter?
Even if you aren’t on the hunt for new investors for your business, it’s essential to make sure your books are up to date. Revenue recognition gives you a great comprehensive look at the financial health and performance of your business. By recognizing revenue according to an accrual accounting method, you’re creating a more accurate representation of your services and goods.
Consider this scenario: You run a consulting business and are contracted to provide your services for six months at a rate of $1,000 per month. This brings your total revenue for this client to an impressive $6,000 over the next six months.
Cash accounting
Under the cash accounting method, you would recognize that $6,000 right away when the money comes into your bank account. It doesn’t matter that the services will not all be rendered right away and will span over the next six months. This means that you will have an overstated account the first month and then an understated one for the months that follow.
The alternative to this would be to categorize this upfront payment as deferred revenue. This would also allow you to postpone recognizing revenue until the services are actually rendered. It gives you the opportunity to break it down into monthly costs, which may be more in line with reports offered by your competitors.
Accrual accounting
On the other hand, accrual accounting only takes the cost of services provided into account. You will only recognize the revenue when the services are delivered. This means that your books will show the $1,000 coming into your bank account each month for the next six months. This shows a far more accurate picture of your company’s finances.
In essence, recognizing revenue is important because it allows you to make your financial status a bit more consistent. It impacts not just the income coming into your bank account. Recognizing revenue in this way also makes your balance sheet and income statement more believable. It shows more consistency in your goods and services.
Because your financial health is in better shape with accrual accounting like this, you have a far better chance of recruiting investors. They will have something to compare your business to, and you’ll be showing them an accurate picture of your finances, making your company look more reliable.
How To Recognize Revenue
Fortunately, this important metric is not as complicated to calculate as it might seem at first glance. Hiring an accountant to help you keep track of things might be helpful, but it is also more than possible for you to recognize revenue in your business on your own.
The entire process starts by examining your contract with the customer to determine how much they’ll pay you in exchange for your goods or services. A solid contract should also include the payment terms. Make sure that the total you are charging is going to account for credits, refunds, or discounts that can impact your bottom line.
Once you have their payment outlined with those specifics, you can start to recognize revenue. Break down the contract into its individual components. Outline what you are charging for each portion of the project or sale, as well as the delivery dates of each stage. Altogether, this helpful breakdown should equal the total amount that your customer is paying.
Keep track of those delivery dates to help you better recognize revenue in a timely manner. Each time a line item is delivered in accordance with the contract, you need to recognize the revenue for that line item in your accounts.
Bringing in Professionals
Sometimes, tracking your income and revenue is a complicated process that requires some help from a professional. If you are looking for Winnipeg accounting services, Compass Accounting is a great place to start. We’re ready and waiting to help you sort out your finances. Give us a call today to see how we can assist in managing your books!