No matter the size of your small business, you should have a set policy on how you recognize revenue. In the accounting world, there is a huge amount of time spent on establishing and ensuring proper revenue recognition. The larger your company becomes, the more important your revenue recognition policy becomes.
I’m going to blow your mind here: Invoicing, Revenue Recognition, and Receipt of Cash are all different things! Just because you’ve invoiced something, that doesn’t mean you should recognize Revenue. And, just because you’ve received cash that also doesn’t mean you should recognize Revenue. It’s possible for 2 or all 3 things to happen at the same time, but it’s important to know how Invoicing, Revenue Recognition, and Receipt of Cash, each impact your financials.
Most small businesses are Cash Basis and for this they recognize revenue when cash is received. You can still have Accounts Receivable, but when it comes to tax time, you are only going to report the cash you received for the year as Revenue.
Now, if you are on the Accrual Basis, here is where all the rules come into play. Under GAAP, all of us silly accountants in the world spend a lot of time ensuring that we are matching the right Revenue to its Expenses. We want to know that on a financial statement if you have Revenue reported in one year, the Expenses related don’t show up in a following year. So – long story short, we need to recognize revenue at the proper time. This results in scary terms like Deferred Revenue, Percentage of Completion, Right of Return, and Multiple Deliverables (just to name a few).
Deferred Revenue is unearned revenue. We record it as a Liability because you haven’t earned the right to recognize it as Revenue yet. Once it is earned, you decrease that Liability and recognize Revenue.
Construction companies usually use Percentage of Completion, a method to recognize Revenue fairly over long-term contracts. Revenue is gradually recognized over the life of the contract to show a more realistic representation of the services performed.
A sale shouldn’t be recognized as Revenue if a Right of Return exists. Generally, this means that the seller has no further duty or liability to the seller. An example of where a Right of Return does exist is when a seller is responsible to assist the buyer in reselling the goods purchased. When this happens, accountants know that a sale has not yet been completed. Also note though that if you can reasonably estimate your returns, you can record those and not have to wait on recognizing the Revenue.
Selling package deals can also affect how you recognize Revenue, this is also known as having Multiple Deliverables. Did you know that if your sale includes being reimbursed for certain expenses (i.e. travel or shipping costs), then those costs should be included in Revenue? Just because you are not making a profit on those items, doesn’t mean it still isn’t Revenue.
You should also note that if you have a sale that mixes both products and services, you may have to recognize those items separately. Basically, if you separate the service from the product or vice versa and it substantially changes the price, then you need to split up those into different Revenue items. Why go to the extra energy? Because, if your service item is a warranty or something else performed over a period of time, you are going to have to record that Revenue proportionally over the time period. With Multiple Deliverables, now you have to explore breaking down sales and recording the Revenue differently for each item!
Yes, it is complicated and confusing, but without these rules in place, earnings of BIG companies would be all over the place. People could lose confidence in the market. There would be all out chaos! That is why civilizations need rules and regulations. Unfortunately, these rules affect every business no matter the size. The larger your company grows, the more you’ll start to hear about these things. Maybe one day you’ll need an audit for financing. You’ll need to worry about being GAAP compliant. And, if you have the goal of one day being public, I bet your love/hate relationship with accounting will multiply several times over. Until that day, just know that these things are on the horizon.
