You check your business bank account and see a large deposit from a new client. It feels like a win. You might be tempted to record that entire amount as income for the month. However, in the world of formal accounting, having the cash does not always mean you have earned the revenue.
Revenue recognition is the accounting principle that dictates exactly when you can record income on your financial statements. It moves the focus from when the money changes hands to when the value is actually delivered to the customer.
For many first-time founders, this concept is frustrating. It seems to overcomplicate a simple transaction. But as your business grows, following these rules becomes the only way to understand if your business model is actually working.
The Matching Principle
#The core logic behind revenue recognition is matching the income you report with the expenses required to earn it. This gives you a realistic view of profitability.
Consider a classic startup scenario. You run a SaaS company. You close a deal for an annual subscription costing $12,000. The customer pays the full amount upfront in January.
In cash accounting, you would book $12,000 of revenue in January and zero in February. This makes January look incredibly profitable and the rest of the year look like a failure. It distorts the data.
Under proper revenue recognition rules, you generally recognize that revenue as you deliver the service. You would record $1,000 in revenue each month for twelve months. You have the cash, but you earn the revenue over time.
Bookings vs. Revenue vs. Cash
#To navigate this, you need to distinguish between three distinct terms that are often used interchangeably in casual conversation but mean very different things to an investor or accountant.
- Bookings: The value of a contract you just signed. This is a promise of future money and work.
- Cash: The actual dollars hitting your bank account. This impacts your runway and ability to pay bills.
- Revenue: The amount of value you have delivered to the customer that can be recognized on the income statement.
Founders often mistake high bookings for high revenue. You can book a million dollars in contracts, but if you have not delivered the product, your revenue is zero. This distinction is vital when speaking to venture capitalists.
When Complexity Arises
#The rules become nuanced depending on what you sell. If you ship a physical product, revenue is usually recognized when the customer receives the item.
Service businesses face harder questions. If you are building a custom website for a client, do you recognize revenue when the site launches? Do you recognize it based on the percentage of the project completed each month?
This leads to questions we have to ask ourselves as operators. Are our contracts structured with clear deliverables? Do we know exactly when our obligation to the customer is fulfilled?
If you get this wrong, you might have to restate your financials later. This destroys trust with stakeholders. It is worth sitting down with a CPA to define exactly what constitutes a delivered service in your specific business model.