Revenue Recognition and the Impact on Your Business

Oct 31, 2022

Businesses pay tax on profits. Profits are generally easy to calculate: money in minus money out (i.e., income minus allowable expenses) equals profit.

So, you record revenue whenever cash payments hit the bank, right? This may be true for cash-basis taxpayers, but accrual-basis taxpayers use a different method for revenue recognition.  

What is the accrual basis of accounting? 

In accrual accounting, companies recognize revenue when earned and expenses when incurred, regardless of when cash changes hands.

For example, say you run a high-end wedding planning service. At the end of December, you sign a contract to plan a wedding taking place one year later. The agreement calls for an initial non-refundable deposit of 25% of your total fee, periodic progress payments at specific milestones along the way, and the balance once the wedding takes place. The client pays the invoice for their 25% deposit in early January.

If you use the cash basis of accounting, this may create a tax problem. It means you have zero income in the first year and a massive profit in the second year, potentially placing you in the 40% tax bracket.

On the other hand, if you use accrual accounting, you could recognize some of the income in the first year and the remaining income in the second year, creating potential tax savings of as much as 50% in your overall tax liability.

Recognizing revenue on an accrual basis means income is recognized based on the following criteria:

  • Once service is complete and an invoice is issued
  • When a contractual obligation is met
  • When the customer can benefit from the actual good or service

Simply put, when an invoice is paid or cash changes hands doesn’t matter for accrual accounting. 

This opens the door to a whole new set of revenue recognition options, making it essential to understand the basics, purpose, tax savings potential, differences amongst methods, and practical avenues of application. 

What is Revenue Recognition?

In June 2020, the Financial Accounting Standards Board issued Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers. This revenue recognition standard outlines the methods and criteria businesses use for recognizing revenue for financial and tax reporting purposes.

Under ASC 606, businesses go through a five-step process to determine whether they should defer or recognize revenue. The general process includes:

  1. Identify the contract. You don’t necessarily need a signed contract. A contract is any agreement with enforceable rights and obligations that has been approved by all parties.
  2. Identify each performance obligation within the contract. A performance obligation is a promise to transfer goods or services to the customer.
  3. Determine the transaction price. The transaction price can include cash and non-cash consideration.
  4. Allocate the transaction price to each performance obligation. You can allocate the total amount of consideration to be recognized as revenue to different performance obligations.
  5. Recognize revenue once the performance obligation is satisfied. Each time you hit a project milestone or deliver promised goods or services, you recognize revenue.

This is nearly identical to the core principles of International Financial Reporting Standards (IFRS) 15, used by more than companies worldwide. However, there are some key differences in revenue accounting and disclosures.

How Can You Save Money with Revenue Recognition?

The revenue recognition process allows certain businesses to report a more accurate picture of income earned in their financial statements and tax returns since they don’t have to recognize income when they haven’t satisfied obligations.

For example, say you have a $20,000 contract with a customer who paid the entire amount upfront, but you haven’t completed any of the work yet. Recognizing the total $20,000 immediately would be overstating your income because you haven’t earned it yet. Revenue recognition allows you to spread that income over months or years, potentially reducing your tax bill. 

Even if you can’t permanently reduce your tax bill with revenue recognition, you can defer a portion to future years. This occurs when you have contracts that span multiple accounting periods. 

For example, say you have three performance obligations in a contract: manufacturing, installation, and service calls. If you only finished the manufacturing portion by year-end, you only need to recognize that portion of revenue and can defer the rest to future years. 

Does Revenue Recognition Vary Between Percent Complete and Completed Contract Methods?

The final revenue amount recognized does not differ between the percentage of completion and completed contract methods. However, the timing of recognizing revenue does vary.

Companies that use the percentage-of-completion method recognize revenue throughout the course of a project when specified performance obligations are met. On the other hand, businesses that use the completed-contract method recognize revenue at the end of the project as there are no specified performance obligations throughout the job. 

How Can I Apply This Information to my Business? 

The revenue recognition principle applies to all businesses that follow U.S. Generally Accepted Accounting Principles (GAAP). Misapplying revenue recognition in your financial reporting could result in fines and penalties from regulatory agencies. 

Properly identifying contracts and implementing revenue recognition policies in your business can seem confusing, especially if you aren’t familiar with the specifics of ASC 606. This is where the team at Prithi Daswani CPA can help. Our approach involves understanding your business and giving you the resources needed to implement revenue recognition accurately. Reach out to a team member today to set up a consultation. 

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