Revenue recognition is an important accounting process for businesses of all kinds, including general contractors and subcontractors. Here’s what you need to know about revenue recognition and the ASC 606 standard.
Key takeaways
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Revenue recognition is the process businesses use to record revenue
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Recognizing revenue when services are completed rather than when payment is received is a principle of accrual accounting and the ASC 606 standard
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Working with financial professionals can help contractors use the right recognition and accounting system for their needs
It’s no secret that revenue drives business growth and success. It’s easy for businesses to be lax on what qualifies as revenue, and many start to recognize revenue too quickly. However, sometimes not all revenue is transferred as soon as a project is complete, especially if a project takes longer or delays between services performed and cash received.
A revenue recognition system helps businesses and contractors create and follow standards for recording and recognizing revenue so that books are always complete and accurate. As a contractor, the accounting method you use (cash versus accrual) will depend on what kind of contracts you have with your customers. However, the Accounting Standards Codification (ASC 606) standard created revenue recognition requirements that you must put in place.
This article will help you understand what revenue recognition is, where it fits into accrual accounting, and what the ASC 606 standard entails.
What Is Revenue Recognition?
Revenue recognition is an accounting principle that details a process for recognizing revenue received (or anticipated) by a business. The recognition process outlines how and when revenue is realized and what qualifies as revenue.
In simpler terms, revenue recognition is when revenue is deemed “earned” and is recorded. For example, when a company sells a product and the customer pays for it, the revenue received in that transaction is recognized by the business immediately.
For contractors, this process can be a bit more complicated. Contractors may have widely different contract lengths or income expected, so it becomes extremely important to have the right accounting process in place to accurately represent the business’s standing.
Accrual accounting
There are two primary accounting methods used by businesses: cash and accrual. Cash accounting hinges on when a payment is actually received by the business, while accrual accounting measures performance based on larger economic considerations, like project completion and service delivery. The accrual method doesn’t account for when a cash transaction actually happens and records revenue when the contract obligations are complete, assuming that the cash will be received in the future.
Revenue recognition is part of the accrual accounting method, which requires that revenue and expenses are recognized in the same period, also known as the matching principle. Revenue is realized when goods and services have been delivered to the customer, not when the contractor receives payment for those goods and services. Thus, “earned” revenue includes goods that have been provided, meaning the activity that generates revenue is complete. And again, according to the matching principle, the costs of the project and the earned revenue must both be reported in the same reporting period.
Both accounting methods have pros and cons. For example, cash accounting is usually simpler to manage and works well for smaller businesses. It may not paint an accurate picture of a business’s financial performance, but it accurately represents the current cash position. The accrual method works well for longer contracts that will have bigger delays between when a project was completed and when payment is in hand.
One important standard was created in the last 10 years that impacts contractors and how they recognize revenue: ASC 606.
What is ASC 606?
ASC 606, also known as Revenue from Contracts with Customers, was created by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). This guidance was created as a uniform standard for revenue recognition from customer contracts. While previous standards were specific to each industry and created fragmentation in what contractors did, this new standard is applicable for all industries.
The ASC 606 principle impacts all businesses that enter into contracts with customers to transfer goods or services. This includes nonprofits, public, and private companies. ASC 606 requires the following steps as its key framework for revenue recognition:
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Identify the contract with the customer
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Identify the performance obligations in the contract
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Determine the transaction price
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Allocate the transaction price
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Recognize revenue when the performance requirements are satisfied
Thus, earned revenue is recognized when the contract obligations are complete, even if cash has not yet been received. The new guidance was created so contractors could implement these principles consistently to eliminate inconsistencies. It streamlines the way that contractors approach revenue recognition and simplifies financial statement preparation. All applicable businesses had to start following this standard in 2018.
Getting the financial assistance you need
These standards and accounting methods can become confusing. When you have questions about how to recognize revenue for your contracting or subcontracting business, talk to a financial professional who can help. You may need to set up an accounting system for the first time, or improve upon the system or already have in place.
One of the most important considerations to keep your business moving forward is an efficient and complete accounting system that uses the latest technologies to improve workflows. You need a simple solution that works so you can focus more time and energy on your business’s primary activities.
Talk to the professionals at Franco Blueprint to learn how we help contracts with their accounting process. Get in touch today for a free consultation with our team.