7 Deadly Sins of Revenue Recognition

There comes a time at every growing startup to switch to the accrual method of accounting. While this may strike fear in some founders’ hearts, it’s actually a move to celebrate. Accrual accounting, whether requested by investors or needed for reporting, creates a more functional and consistent picture of business operations, particularly when booking revenue.

The Golden Rule 

Revenue recognition in GAAP or accrual accounting is driven by the FASB Accounting Standard ASC 606. Before ASC 606 there were many differences across industries and products/services in how revenue was recognized. The introduction of ASC 606 brought consistency and dependability to arguably the most important line on the Income Statement. (In the accounting world, this was a big deal.) 

The five steps below are the basis of ASC 606. When you complete all five steps, you can recognize revenue.

Step 1: Identify the contract with a customer 

Step 2: Identify the performance obligations in the contract

Step 3: Determine the transaction price 

Step 4: Allocate the transaction price 

Step 5: Recognize revenue when or as the entity satisfies a performance obligation

While the five steps above can seem simple, applying them to your unique business situations can be extremely difficult. For example, how should construction, or developers recognize revenue when their projects take years to complete? How do you recognize subscriptions paid upfront vs. one paid monthly? Or, what if your product takes weeks to deliver to your customers?  

We not only see start-ups struggle with these questions, but also with implementing the right recognition process once they have the answers. Implementation of revenue recognition comes down to having access to the right sales data and understanding what it means. 

The 7 Sins 

We have compiled the top seven mistakes we see companies make when they try to switch from cash to accrual (or are currently implementing accrual) and hope these tips can help you avoid the same mistakes. 

1. Recognizing Net sales instead of Gross Sales – Are you simply booking those Shopify and Stripe deposits as they come in the bank? Then you are missing out on higher topline line growth because the deposits already have had discounts, refunds and processing fees subtracted from them. The correct way to recognize sales for both cash and accrual based accounting is to have an account line item for Gross sales, Discounts, and Refunds in the Gross Profit section of your Income Statement. Merchant Processing fees are broken out in your Selling Expenses section.

2. Recognizing sales tax collected as revenue – Another, more frowned upon method of booking sales, includes booking the amount you collected for Sales tax in Gross sales. If you break out sales tax to the customer at point of purchase (As most US companies do), then you must hold this amount in a Sales Tax payable liability account until you pay the state sales tax due.

3. Recognizing subscription revenue upfront – An especially deadly mistake for our SAAS clients. Subscription revenue must be recognized over the life of the subscription, not when you received payment for it. This has a great impact to your topline because it makes income less volatile month to month. For example, a $12,000 annual subscription to Time Tracker Pro should have $1,000 for each of the 12 months the subscription is in use.

4. Recognizing the sale date instead of the shipping date – Many CPG companies switching to accrual look to Shopify or other point of sale tools for their sales number. But Shopify doesn’t reflect the day your product actually ships – just the date your customer swipes their credit card. ASC 606 allows organizations to recognize revenue either when product ships or is delivered to the customer. Depending on the product, this can be anywhere from days to months after the ‘sale date’ on Shopify.

5. Recognizing cancelled or unfulfilled orders – Shopify or other sales platforms can also incorrectly show unfulfilled, cancelled or updated orders as sales. This is where understanding how your data is captured and displayed is extremely important. The best way to avoid booking incorrect orders is basing sales directly from your fulfillment warehouse’s records, and what products actually go out the door. 

6. Recognizing Invoice date instead of service date – If you are a company that invoices your customers, you know the administrative pain of sending invoices each period. Sometimes it’s such a pain that they get sent days or weeks late – that’s okay. However, just because your invoice was sent in September doesn’t mean it should be counted as September revenue if the actual service was provided in August. Bookkeeping platforms such as Quickbooks and Xero automatically recognize revenue on the invoice date, not the service date so you will have to create journal entries to adjust accordingly. 

7. Not writing off bad debts – Have clients that haven’t paid in over a year, or ones where you know you’ll never see that cash? Write them off as a bad debt. There are multiple ways to account for bad debts depending how often you see them, but you should never go back in time and ‘erase’ the revenue you didn’t receive. Instead, it should be recorded as a bad debt expense on your Income Statement.

The Bottom Line 

While ignoring these ‘deadly sins’ of revenue recognition all together can hurt the truthfulness and accuracy of your financial statements, it's important to point out that unaudited financial statements are not expected to be perfect. No reasonable investor expects a seed series company to spend thousands on an ERP system, when you have less than a year of runway and new product launches or a supply crisis every other day. Painting an overall accurate picture of your company, and communicating any reporting shortfalls to your stakeholders is the end goal of revenue recognition for a start-up company.

This article was written by Samantha Golaski