Revenue recognition may be a mysterious concept to a lot of software startup founders, but it is an important accounting concept to understand when running a business.
Revenue Recognition Criteria
When a product or service is sold, certain conditions must be met for that product or service to be recognized as revenue. If you sell a 1 year software subscription for $1,200 in January, you can not recognize all $1,200 as revenue in January. It must be spread across the entire span of the subscription.
The criteria for recognizing revenue are:
- persuasive evidence of an arrangement exists
- delivery has occurred
- the software vendor’s fee is fixed or determinable
- collection of fees is probable
This is especially important for software companies who sell annual software agreements, charge maintenance fees, or do custom software development.
Revenue recognition can be handled by creating a new liability account called Deferred Revenue. This is revenue that you have collected money for, but cannot recognize as revenue yet based on the criteria described above.
The journal entries might look like:
Record the entire amount against deferred revenue
Each month, recognize 1/12th against revenue
Why is revenue recognition important for startups?
Software companies who might pursue investment from venture capital firms will most likely be asked to provide financials that follow these guidelines. It’s beneficial to start doing this early to avoid re-stating revenue for past years.
Financial institutions, much like venture capitalists, will require revenue to be reported that meet these standards. You may be required to prepare statements in accordance to GAAP and provide these as part of your terms for financing.