What is Revenue Recognition and How does PSA Improve it?
PUBLISHED: APRIL 2019
As services organizations grow, the process of recognizing the revenue that has been accrued during a reporting period becomes more complex. It becomes increasingly difficult for a services organization to accurately recognize revenue as more commercial structures and billing types come into the mix.
This article will discuss the importance of investing time and energy in understanding exactly how your organization should recognize revenues for each financial reporting period. Services organizations that are planning to scale often consider investing in a software solution such as professional services automation (PSA) that can help to automate or aid in the revenue recognition process.
What is Revenue Recognition and Why is it Important?
Recognizing revenues may seem to be a simple concept at first glance, but it is actually a very complex process that has a direct impact on the success of the business. Revenue recognition is an accounting principle that outlines when it is appropriate for companies to record and recognize revenues – one of many accounting standards involved in accurate financial reporting.
The revenue recognition principle puts limits on when companies can record revenues – an organization is required to recognize the revenue that has been accrued within a given accounting period. Organizations must accurately recognize revenues or their financial statements will not be accurate. According to the revenue recognition principle outlined in SEC guidelines, “revenue should not be recognized until it is realized or realizable and earned. Revenue is realizable and earned when all of the following criteria are met”:
Persuasive evidence of an arrangement exists
Delivery has occurred or services have been rendered
The seller’s price to the buyer is fixed or determinable
Collectibility is reasonably assured
What is the Revenue Recognition Principle?
Recognizing revenues may seem to be a simple concept at first glance, but it is actually a very complex process that has a direct impact on the success of the business. Revenue recognition is one of the many accounting standards involved in accurate financial reporting. The revenue recognition principle puts limits on when companies can record revenues – an organization is required to recognize the revenue that has been accrued within a given accounting period. Organizations must accurately recognize revenues or their financial statements will not be accurate.
It is important to note that while revenue recognition is an accounting principle, the impact of poor recognition will be felt throughout the entire organization, not just the finance department. Recognizing revenues with accuracy allows businesses to make proactive, rather than reactive, decisions. The lack of a rigorous process for calculating revenue recognition in a timely manner will force management to make business decisions based on inaccurate or untimely datasets. Where companies are not conforming to the most up-to-date revenue recognition policies, it can be difficult to get an accurate picture of profitability of the business. Accurate and timely revenue recognition also has a direct correlation with accurate revenue forecasts for upcoming periods, a crucial aspect of building the company’s strategy.
When revenues are recorded in the incorrect business period, income statements will show more profit than was actually earned in that period. Alternatively, revenues that were recorded prior to being earned will cause later financial statements to reflect lower profits. Incorrect revenue reporting causes a major ripple effect on all financial statements following the miscalculation.
Complexities of Recognizing Revenue at Services Organizations
While relatively straightforward in many sectors, revenue recognition can be a particularly complex matter in professional services, because work is performed under an array of different commercial structures to accommodate complex deliverables.
Commercial structures refer to different methodologies for collecting revenue and calculating revenue recognition. Some prominent commercial models in services organizations include, but are not limited to, time and materials, cost complete, and effort complete. The revenue recognition calculation is not consistent from one commercial structure type to the next, exacerbating the already complex process of closing an accounting period and finalizing revenue recognition. For example, an effort-percent complete structure requires different recognition methodologies than a project with a time-percent complete commercial structure.
According to a Kimble White Paper on simplifying revenue recognition, “As a professional services business grows the proportion of revenue generated by larger projects rather than simple time-hire contracts increases, and the proportion of these projects undertaken on a fixed price basis usually increases as well. This introduces complexity into a business; rather than recognize revenue based on cash received or invoices sent out, the revenue in your monthly P&L for a piece of work should reflect the level of completion, the risk of additional costs and the risk of not getting paid.”
Cost Percent Complete Example
It is common for services organizations to use a fixed price cost percent complete model to recognize revenue. Since the calculation takes into account the costs that have been incurred across both time and resources, fixed price cost percent complete tends to be the most rigorous and accurate way to track revenues, especially at services organizations where there will often be a variety of different resources working on a project at different cost rates.
So while using an effort percent complete model to calculate revenue recognition only accounts for the percentage of work done on the project, it does not account for cost variance from one resource to the next. Cost percent complete builds in an understanding of the difference in cost between work done on an engagement by the junior consultants and the senior consultants on an engagement, providing a more accurate picture of the revenue you should recognize on that engagement.
To properly use a cost percent complete model, the following information must be available:
- total project framework, including timeline and forecast effort
- amount of resources assigned to the project
- type of resources and the cost of those resources
- total cost of the project
- total project revenue
- the exact progress of the project against the forecast effort, broken down by resource
Cost percent complete requires a number of inputs to calculate, and it becomes very difficult to execute an up-to-the-moment revenue recognition calculation without all of this information readily available at your fingertips.
How can Software Improve the Revenue Recognition Process?
For many service organizations in today’s environment, it simply becomes unmanageable to recognize revenues through spreadsheets because of the sheer number of factors that feed into the process. In order to scale, it becomes necessary to have business insights available at your fingertips. To gain this immediacy to insight, organizations automate the revenue process through technology such as professional services automation (PSA) software.
Both small and large organizations use manual recognition methods that tend to be time-consuming, complex, and difficult to maintain. But manual revenue recognition leads to delays in invaluable forward-looking revenue forecasts that help leaders make decisions about the direction of the business. These delays make decisions reactive rather than proactive in nature since they based on events that have already happened and impacted revenues. Delays in recognition also tend to undermine trust which further inhibits speedy and effective decision making. Professional services automation software can aid in streamlining the once manual and laborious process of revenue recognition, ensuring your organization has a clear vision of where it’s been as well as where it’s going.
Professional services automation (PSA) software runs all revenue recognition calculations automatically and seamlessly in the background. Due to the myriad inputs that are involved in recognizing revenue, any shifts in plan are difficult to manage without automation. One thing that any individual in services can confirm is this: changes will occur across the project lifecycle. In today’s complex services world, technology can automate those shifts so that one when one input changes, the revenue is automatically recalculated and recognized.
For example, with Kimble PSA, the changes in cost or rates of resources are changed in real-time and you can automatically see how this impacts the revenue being recognized. Instead of seeing the impact after it has already occurred, intelligent PSAs like Kimble allow users to see how any changes across any of the dimensions of data impact the overall revenue.
This flexibility through automation frees up the individuals who were previously dedicated to chasing down data through email and calculating revenue recognition in spreadsheets that were hard to manipulate, allowing them to spend their time actually analyzing the data that’s aggregated during the revenue recognition process instead. Additionally, PSA applications reduce the lag time associated with most revenue recognition approval processes. With PSA, revenue for an accounting period can be recognized expediently, and decisions that require that input can be made with enough time to positively impact the business.
Four Benefits of Recognizing Revenue with Professional Services Automation (PSA) Software
Automated data collection increases the quality of data inputs
You may be asking, what is Professional Services Automation (PSA) software? PSA closes the gap between sales, resourcing, and delivery teams, which otherwise tend to become siloed as your business grows. It can be difficult in growing services organizations to keep all teams on the same page without one central location for updated project statuses and data. The PSA application not only serves as the central hub/the one source of truth, but it also prompts these once siloed teams to collaborate and keep their data accurate. Automated data collection is critical as the revenue forecast becomes skewed when it is fed with inaccurate information. The calculations are only only as good as the currency and accuracy of the input data. If your get everyone pushing for currency and accuracy of base data then all of the calculations produce better insight for everyone involved. PSAs circumvent the issue of data quality by automating the collection of these inputs.
The actual calculation of revenue recognition becomes an automated task with automated inputs
At most companies, the revenue recognition process is not an automated one. Professional Services Automation (PSA) software turns the revenue collection and calculation process into an automated and instantaneous process that simply runs in the background. A PSA reduces overhead costs and increases efficiency as it typically frees up the individual or team that was once dedicated to aggregating revenue data in spreadsheets. This allows those individuals to spend more time analyzing, rather than collecting, data. And since revenue recognition numbers for an engagement, account portfolio or business unit are calculated in real-time, there’s no need to pause and run the numbers – reporting on progress against targets can be done in the moment, with mitigation plans put in place to ensure the business stays on the right track.
Automatic re-calibration when changes occur
There are numerous factors that affect the recognition of revenue, and due to the nature of the services industry, there are many moving parts to consider. Changes are inevitable and you need a tool that will automatically and instantly react to any inputs that could impact revenue. A PSA will automatically shift and re-calibrate your revenue when certain inputs are edited. An intelligent professional services automation software tool will be able to handle change and show you the revenue impact almost immediately.
Period close and revenue recognition become more agile
PSA enables organizations to close down a period and lock in revenue recognition numbers for a period much more quickly than manual methods. Without a PSA, organizations run the risk of having delayed revenue recognition calculations, which may lead to unrecognized or lost revenue being left out of revenue forecasts for subsequent periods. Take for example, a lucrative opportunity that was projected to close and start within the current period but it’s status has not been updated It is important to catch these inconsistencies while closing periods and to act on them quickly, because the revenue forecast will not be accurate until you understand if this means:
A) The opportunity was won but the sales person didn’t update it in the system.
B) The opportunity was lost and not updated in the system.
C) The sales team is still fighting to win the opportunity but the close date needs to be pushed out for the revenue forecast to be accurate.
PSAs ensure that you have an aggregate view of all the revenue that hasn’t been actualized during that period but may actually come later. Even if you have the best process or systems to support revenue forecasting, if the revenue recognition for a period takes weeks or months to get approved by finance, you will never have an accurate forward-looking picture of the business.