For those unfamiliar with advanced business and financial management, the concept of revenue recognition may seem straightforward. It may even seem self-evident: the purpose of revenue recognition is to recognize revenue.
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However, in truth, revenue recognition is an overly complex financial reporting standard that directly and significantly impacts the sustainability and profitability of various projects, as well as the success and strength of an organization. An alternative is revenue forecasting, which considers the same revenue elements without going through the actual accounting process. Revenue forecasting is meant to give companies a close enough idea of the revenue to make decisions but may not be accurate down to the penny.
Professional services revenue recognition can be especially challenging. This is because as professional services organizations mature and grow, the proportion of revenue generated by larger fixed-price projects often increases relative to simpler time-hire contracts. As a result, the revenue recognition paradigm shifts and becomes much more complex.
Instead of recognizing revenue based on invoices or cash received, companies must capture revenue based on the level of completion, the possibility of additional risks, and the potential risks of default (i.e., not getting paid).
Accounting and consulting firm Cohen & Co also notes additional complexities for software and SaaS companies that provide custom development, training, and other professional services. To accurately recognize revenue, such organizations must determine if they sell their services on a standalone basis or if customers can hire third parties to obtain these subscription services.
Each scenario indicates that services are separate from the software or SaaS subscription, and as such, revenue can be recognized when the service obligation is complete. Plus, specific services can be delivered over a period that, per contractual provisions, requires professional services organizations to achieve certain deliverables and/or reach specific milestones before customers will officially accept services (or a phase/component of services) as complete.
In these scenarios, professional services organizations must assess if customers have the capacity-to-revenue benefits for services rendered. If so, then revenue should be recognized then. If not, then revenue recognition must wait.
One of the most significant changes to the principle and process of professional services revenue recognition is Accounting Standards Codification (ASC 606): the most recent revenue recognition standard developed jointly by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).
We see global compliance synced across all accounting standards, ensuring revenue recognition aligns with ASC 606 or IFRS 15 with a billing solution that ensures compliance.
ASC 606 provides a uniform framework for recognizing revenue from contracts with customers. We dive deeper into ASC 606 later in this article. First, let us set the foundation by clearly defining revenue recognition.
What Is Revenue Recognition?
Revenue recognition is a generally accepted accounting principle (GAAP) that stipulates how and when revenue is to be recognized. The revenue recognition principle, which aligns with SEC guidelines, holds that revenue is realizable and earned when four criteria are satisfied:
- There is persuasive evidence of an arrangement (e.g., contract).
- Delivery has occurred, or services have been rendered.
- The seller’s price to the buyer is fixed or determinable.
- Collectability is assured.
Notably, “when invoices are sent” or “when cash is received” are not part of the revenue recognition suite of criteria. This is not an oversight. Per ASC 606, using these criteria for revenue recognition is no longer acceptable.
In other words, invoices and payment can, and often do, occur before revenue recognition. Once certain conditions are met, organizations must realize revenue — and accurately calculate, track, and report it.
What Is the Relationship Between PSA and Revenue Recognition?
For organizations looking to understand professional services revenue recognition, they should also consider the relationship between them. Every piece of data matters in revenue recognition. Without critical project financial data — including bookings, billings, and revenue to report on project profitability — professional services companies face a lack of real-time visibility for decision-making, missed adjustments, and reduced margins.
Fortunately, today’s advanced PSA solutions create a powerful ecosystem to facilitate revenue forecasting and send data to the ERP for complete revenue recognition. The data sent usually consists of time records, milestones, percent complete, and other revenue events. This tightly integrated approach provides companies with accurate revenue information.
The revenue recognition method selected must also align with the requirements of a contract and/or a customer’s preferences. We explore some of these methods in the next section.
Revenue Forecasting vs Revenue Recognition
Many professional services companies use revenue forecasting in addition to revenue recognition. Although similar, revenue forecasting is meant to give a close idea about what revenue is coming to help make decisions. Revenue recognition is the actual accounting process that must be accurate down to the penny.
Revenue forecasting can give companies an accurate view of their revenue without going through the entire revenue recognition process. When paired with revenue recognition, companies can have real-time data to make strategic decisions and follow through with complete accounting processes.
What Are the Methods and Rules of Revenue Recognition?
There are multiple methods of professional services revenue recognition. Here, we’ll take a closer look at three common methods: time and expense-based, fixed-fee deliverables, and product (or service deliverable). We also highlight the rules (calculation formulas) for various options available with each method.
Time and expense-based
- Basis for calculating time: # of approved hours x billing or cost rate
- Basis for calculating expenses: approved expenses x % of expenses considered billable
This method is usually combined with a fixed-fee engagement in which the expenses are considered billable.
- Basis for calculating physical percent complete (% of completion): an estimate of the actual amount of work completed (total actual hours/total planned hours). Note: This is based on an estimate of the actual amount of work completed. As such, this value can reflect a higher or lower percentage than the exact number of approved work hours would suggest.
- Basis for calculating physical percent complete (cost): budgeted cost-to-date / total budgeted costs (for all fiscal periods, past and present).
- Basis for calculating effort expended: monetary value of the actual number of approved hours of billable work x billing or cost rate. Note: This is like time and expense-based, except that the customer is billed a fixed amount regardless of the actual time spent on the work. As such, tasks must be associated with a fixed fee deliverable.
- Basis for calculating x% of total deliverable (milestones – scheduled percent): applying a percentage of work for a deliverable that is expected to be completed by a specific date x billing amount for the deliverable. Revenue is recognized as each milestone date passes.
- Basis for calculating $x recognized (milestones – scheduled dollars): the billing amount is divided evenly over a range of dates or can be adjusted to reflect different levels of work completed at different stages of the deliverable. Revenue is recognized as each milestone passes.
Product (or services deliverable)
- Basis for calculating physical percent complete (percent of completion): an estimate of actual amount of the product (or service) delivered. A separate percentage is applied to each product within the engagement, and a dollar value is calculated by applying that percentage to the product’s extended price (standard or negotiated).
- Basis for calculating x% of total deliverable (milestones – scheduled percent): applying a percentage of the product that is expected to be completed by a specific date x billing amount for the deliverable. Revenue is recognized as each milestone date passes.
- Basis for $x Recognized (milestones – scheduled dollars): estimate a portion of the total product (or service) price (standard or negotiated) earned by a specific date. The price can be divided evenly over a range of dates or adjusted to reflect different levels of product (or service) delivery during the project. Revenue is recognized as each milestone date passes.
Read next: Professional Services Capacity Planning
Billing and Revenue Recognition
Although billing and revenue recognition are similar and connected, from an accounting and legal perspective, they are distinct for two reasons:
- Billing refers to requesting or receiving payment for rendering a product, service, or both.
- Revenue recognition is based on the value of a product or service delivered to a customer and when delivery occurred. Per GAAP rules, revenue can only be recognized once earned — not necessarily when invoiced or cash is received.
In accounting, the billing path and revenue path run parallel. Planview’s PSA system feeds that data to the ERP, which calculates billing and revenue recognition. Planview’s PSA software doesn’t strictly conduct revenue recognition processes on its own. That data related to revenue forecasting feeds the information to the ERP. In this sense, billing and revenue recognition work together to provide an accurate view of a company’s revenue.
What Is the Relationship Between Billing and Revenue Recognition?
To achieve accurate revenue recognition processes, the billing path and the revenue recognition path run parallel — but they are not the same path (although they eventually reconcile at the end). Billing is the process of executing to complete and request payment from the customer (typically in the form of an invoice).
Revenue recognition is applying ASC 606 principles that officially allow organizations to report revenue.
Let us look at two simple examples of professional services revenue recognition:
- Example 1: In its contract, professional services organizations have a milestone that allows it to bill for providing phase one deployment of a new feature in a solution. The milestone is reached, so the organization submits an invoice and is paid. However, the feature in question has not yet been released to the customer. Although the professional services organization receives payment for the invoice, it can’t legally report the amount as revenue. Why not? Because it still needs to deliver the final product.
- Example 2: A professional services organization completes its work on a new feature in a solution and delivers it to the customer. At the end of the month (and per its contract), the organization will submit an invoice for services rendered. However, since the work is done and the customer has realized a benefit, the revenue must be recognized and reported now — even though an invoice has not been sent and cash has not been received. (Refer to the previous section on professional services revenue recognition methods for how professional services organizations can properly calculate and report this amount).
A Closer Look at Project and Revenue Recognition
Projects drive revenue, but only finance recognizes revenue. Project managers need access to revenue forecasting to stay connected to revenue goals and strategies. The PSA calculates revenue forecasting and feeds the needed elements to the ERP system for full revenue recognition.
A robust PSA ecosystem allows services managers to track their revenue accurately without waiting for finance to run revenue recognition. Revenue forecasting allows project managers to make strategic decisions to move their projects in the right direction.
However, revenue forecasting isn’t accurate to the penny. This process will be meaningfully accurate so that services and financial leaders can make decisions. The ERP system can provide precise revenue recognition and feed that data to the PSA system.
What is the relationship between project and revenue recognition?
Many of the same rules apply here as with billing. If the ERP system puts the revenue recognized into the proper accounting period, it will be acceptable from a financial accounting perspective.
Only finance recognizes revenue. This is where revenue forecasting becomes crucial. Revenue forecasting allows project leaders outside of finance to track revenue goals in real time without going through the entire revenue recognition process. The more project leaders and the PMO can see daily regarding the individual progress of the project, the better they can adjust the project to bring revenue in sooner than just trying to meet delivery dates.
What is asc 606 revenue recognition?
Earlier, we referenced the ASC 606 revenue recognition standard. Developed jointly by the Financial Accounting Standard Board (FASB) and International Accounting Standards Board (IASB), the ASC 606 revenue recognition standard went into effect at the start of 2018 for public companies and at the start of 2019 for private companies.
ASC 606 establishes a 5-step process for correctly and consistently applying the core principle to transactions generating revenue:
Identify the contract with the customer
- All parties must approve the contract.
- All parties must be committed to fulfilling their respective obligations.
- Each party’s rights must be identifiable.
- The contract must have commercial substance.
- Collectability is assessed to be probable, and payment is likely to be received.
Identify the performance obligations in the contract
- All deliverables and commitments must be identified and understood.
- A determination must be made whether the deliverables and commitments will be accounted for together or separately.
Determine the transaction price
- The amount must consider discounts, rebates, and incentives and exclude third-party obligations such as sales tax.
- For considerations that are of variable amounts, there must be a good faith estimate of the amount to the extent that it is likely that a significant reversal in the amount of the revenue recognized would not occur when the uncertainty associated with the variable is resolved.
Allocate the transaction price to the performance obligations
- Map what has been promised (and when) to the amount of compensation expected based on the standalone selling price of each good or service.
- Of particular importance for professional services revenue recognition: variable cost estimate considerations require additional scrutiny to correctly apply ASC 606 revenue rules as they pertain to goods or services that make up a series but are treated as a single performance obligation.
Recognize revenue when (or as) each performance obligation is satisfied
- The amount recognized is allocated to the satisfied performance obligation established in the previous step.
- Obligations can be satisfied at a point in time (usually when promised goods or services are transferred to a customer) or over time (which usually applies to services delivered to a customer across a duration of time).
ASC 606 Revenue Recognition and Professional Services
In professional services, revenue recognition is about breaking the contract into logical components based on the obligations that will be delivered and when.
In theory, this may seem straightforward. However, in practice, it can be complex, especially when variable considerations are part of the commitment. These require an additional inspection to correctly apply ASC 606 revenue recognition rules. Particular attention is paid to distinct services or goods that are part of a series of deliverables but are viewed as a single contractual obligation.
Typically, in professional services, contractual obligations are satisfied over a period of time, instead of at a point and time. As such, it is crucial to establish an accurate method of monitoring, tracking, and reporting progress. It is just as important to integrate project and financial reporting to generate credible forward-looking projections.
What is the relationship between asc 606 revenue recognition and professional services?
As discussed above, when managing fixed-price projects, professional services organizations must achieve two core objectives: accurately recognizing revenue per ASC 606 rules and using suitable forecasting methods to ensure that projects stay on track. PSA solutions play a pivotal role in achieving these objectives and managing complexities.
Read next: Integrating PSA Systems for Your Professional Services Organization
Revenue recognition is a complex financial reporting standard that directly and significantly impacts projects’ sustainability and profitability. For similar results and strategic planning, revenue forecasting gives companies an accurate prediction of their revenue.
To be successful and profitable, professional services organizations must fully understand revenue recognition methods, ASC 606 reporting obligations, and how to leverage a PSA and ERP solution for effective revenue forecasting and recognition. The Planview PSA completes revenue forecasting and passes the data to the ERP to complete the revenue recognition and billing.
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