MaRS Library When to recognize revenue as earned: Key concepts
Knowing when to recognize revenue as earned is an important part of the accrual basis of accounting. The variation in how products and services are sold has resulted in numerous rules and policies governing when to recognize revenue. To further complicate the topic, some differences exist between different accounting standards.
When can you recognize revenue as earned?
For the sale of goods, revenue can be recognized when both:
- The risks and rewards of ownership have been transferred such that the seller has no remaining obligations
- The amount of consideration can be measured
For services and long-term contracts, revenue should be recognized as earned when the work progresses and the amount of consideration (i.e., the amount that you will receive in payment) can be measured.
Collection must be reasonably assured to recognize product or service revenue.
In some cases, it is clear when these conditions have been met and the revenue earned should be recorded. When the conditions have been met, if payment has not yet been received, then the revenue should be recognized and an account receivable be should be recorded. If payment is received before product is delivered or services provided, then deferred revenue should be recorded. This is important, because when revenue is recognized, it will generally become taxable.
When to recognize revenue: Common startup challenges and key concepts
Undelivered elements and percentage of completion
If a significant portion of goods or services are delivered, but there remain some undelivered elements, not all of the revenue should be recognized, unless the undelivered elements are insignificant.
The challenge many companies have is determining how much should be allocated to each of the elements. The amount allocated to each should be the fair value of that element if it were to be sold on its own, with any discounts prorated across all of the deliverables.
For example, where a product is being sold and a software license or a service contract is included for 12 months, then a portion of the revenue earned will relate to the licensing or servicing. In this case, you will need to determine the amount of consideration that relates to the undelivered portion of the goods or services and defer it. The revenue related to the licensing fee would likely be recognized evenly each month over the following 12 months.
Revenues for ongoing services, such as custom projects or research and development contracts, are generally recognized based on the percentage of completion. In determining the percentage of completion, different factors are considered to measure the progress made and to calculate the amount of revenue earned. For example, this may be the total expected costs to complete the project compared to costs incurred to date, or the total number of hours to complete the project compared to the number of hours to date.
If you apply for a grant and there is nothing further that you need to do in relation to that funding, then the full amount should be recorded as revenue at the time the payer agrees to give you the funds. This is because you have done everything needed to ensure the payment and the amount and timing of its receipt is known.
However, if the grant is for work on future projects, then the amount should not be recorded as revenue until you meet the specific criteria in the agreement related to receiving the grant.
Loans are generally never recorded as revenue. A loan is recorded as a liability that will need to be repaid. However, if the loan is forgivable, it can generally be recorded as revenue when it is reasonably assured that you will not need to repay it.
Tax credits and other incentives
Tax credits and other incentives such as support payments should be recorded as a revenue if it is reasonably assured that they will be received. For example, if a claim has been submitted and you know how much you are likely to receive (i.e., similar claims in the past have been accepted), then it is reasonably assured that you will receive the current amount.
Generally, where government incentives are realized as costs are incurred, the government incentives are recorded as a reduction of the related expenses.
- Sample NDA: Non-disclosure or confidentiality agreement for asset purchase transaction.
- Current liabilities and long-term liabilities on the balance sheet.
- The accounting equation and double-entry bookkeeping.
- Payroll basics: Payroll deductions and employee benefits taxation.
- Lean practices for startups: Lean accounting.