By Danny Wong
Recognizing revenue is a vital part of the accounting process, and your ability to record revenue accurately, consistently, and appropriately impact every aspect of your operations.
That is just one reason why maintaining standards for revenue recognition on contracts is so important. Agreements can mean many things to many people, and malicious companies try to find ways to over- or under-report revenue to improve their situation. That’s why specific, observable criteria must be met before you can count revenue as earned. With the proper conventions in place it is less likely that people will make mistakes that could confuse observers, and it is more difficult for unscrupulous people to cheat the system to their advantage.
Accountants and regulators place a great deal of importance on revenue recognition because it is the origination point of many financial indicators and a key financial indicator on its own. The amount of revenue earned is used to determine net income, available cash, and tax liabilities. When the amount of revenue recognized on the books is significantly inaccurate, it sends ripples throughout all segments of the organization.
Before getting into the details of the new standard revenue from contracts with customers, it will help to specify what a contract is and what it isn’t. Many people without a legal background often have a vague idea in their head of what constitutes a contract, but may not understand the actual components that must be present in order for a contract to be valid and enforceable.
Essentially, a contract is an agreement between two or more parties to perform some kind of act, or, in rare cases, to not do something. Contracts are legally enforceable as long as they contain all the necessary elements for validity.
All contracts have to be based on some kind of offer. The offer can take many different forms, including a product, service, action, or other. Once the offer has been established, another party must accept that offer. After acceptance, the accepting party then offers something else of value, which is known as consideration. In business settings, of course, the consideration is typically a monetary payment for the product or service, but it can be anything that has value to the seller.
When these criteria have been established, the parties involved in the contract must signal their intent to enter into a legally binding agreement. They have to show that they are aware they are entering into a contract. It’s important to note that while most contracts are written, verbal contracts that contain all these elements are also legally binding.
You must be able to record revenue accurately in order to monitor your cash on hand, forecast, determine budgets, assess your tax liability, and more. It is the base of the entire financial picture of the organization. This five-step plan is important because it makes the process more transparent for companies and gives them a simple template to follow for addressing questions about revenue. When you have questions about whether or not revenue is valid, you can refer to the steps to determine if you have fulfilled all of the necessary obligations.
Many companies are not going to collect 100% of their revenue. However, you should be relatively assured that you are going to collect most of it. When it is in doubt as to whether or not you will collect any of the revenue from a sale, even if all parts of the five-step plan have been completed, then you should refrain from recording the revenue until you collect payment.
In closing, remember that revenue and cash are not equal, and that recognizing revenue does not mean you will get paid immediately or completely. There are plenty of companies logging large amounts of revenue that are in precarious cash positions. Likewise, there are some companies that can sell very little during a period and operate entirely off their rich cash reserves. Regardless, accurate reporting is key, and doing so according to the new revenue recognition principle will help your company in the long run.