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Revenue Recognition: The Entrepreneurial Mind versus GAAP

Start-ups and the entrepreneurs who lead them are often coming up with new ways to sell and deliver their innovative products and services.  That’s your job and you do it well. What you are probably not taking into account is Generally Accepted Accounting Principles, or GAAP. As a result, when it comes time to think about revenue recognition for these products and services there is often no shortage of misunderstanding and debate.  But that’s the accountant’s job so here are some common misconceptions we see when translating the revenue model to GAAP.

A non-refundable fee means that my company can recognize the revenue when we get paid.

Unfortunately it’s not that simple.  Payment is only one of the criteria for revenue recognition under GAAP.  There are four criteria that must be met prior to revenue recognition – 1) delivery of the product or service 2) the fees are fixed or determinable 3) persuasive evidence of the sales arrangement exists and 4) collection of the fee is reasonably assured.  And if you haven’t delivered the product or service, you probably can’t recognize revenue even though you’ve been paid in full.

The sales contract states that I can bill my customer monthly, so I can recognize revenue monthly when it’s billed.

The agreed upon billing cycle in a sales arrangement is not necessarily indicative of when products or services are delivered.  For products or services delivered over a period of months or years, it’s important to consider the pattern of delivery, when the customer is receiving the benefit of the product or service, and to what extent that the item is delivered alongside other products and services.   Is the customer receiving the same service on a monthly basis?  Are consulting services offered along with the software subscription?  Are these services able to be separated, meaning could they standalone from each other? Could they be sold separately?

What matters is how my company incurs the costs to deliver the product or service.

Revenue recognition follows the transfer of benefits or services to the customer.  Costs incurred may or may not be a good indicator of the timing in which value transferred to the customer.   A company may have minimal costs after a short initial set-up period but the value being transferred, which is what the customer is really buying, could take place over a significantly longer time period.   

GAAP wasn’t designed to be as flexible as the entrepreneurial world may like but that’s why it’s so important to have someone on your team who can help make the translation. Whether you have a controller, CFO, or third-party accountant to help you figure it out, ask the questions now before your investors starting asking later.