What is Revenue Recognition and How Does Professional Services Software Improve it?
By Team Kantata
As professional 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 whitepaper 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 purpose-built software solution that is designed to help businesses automate or aid in the revenue recognition process.
What is the Revenue Recognition Principle?
Financial data is only as reliable as the revenue recognition process behind it. Revenue recognition is an accounting principle that outlines when it is appropriate for companies to record and recognize revenues. In order for organizations to trust that their financial reporting and forecasting is accurate they must have systems and processes in place to support a repeatable and reliable approach to revenue recognition.
The revenue recognition principle standardizes how companies record revenues. It requires an organization to recognize the revenue that has been accrued within a given accounting period. If an organization fails to do so, their financial statements, reports, and forecasts will be inaccurate and untrustworthy.
1. Persuasive evidence of an arrangement exists
2. Delivery has occurred or services have been rendered
3. The seller’s price to the buyer is fixed or determinable
4. Collectibility is reasonably assured
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”
The Consequences of Inaccurate Revenue Recognition
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 and refining 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 Professional 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-percent complete, and effort-percent 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.
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, 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.
The Shift Beyond Manual Revenue Recognition
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 recognition process using purpose-built software specifically designed for the unique needs of professional services organizations — such as professional services automation (PSA) software or Industry Clouds for Professional Services.
Both small and large organizations use manual recognition methods that tend to be time-consuming, complex, and difficult to maintain. 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 are based on events that have already happened and impacted revenues. Delays in revenue recognition also tend to undermine trust in data, which further inhibits speedy and effective decision making. The right technology can help businesses streamline the once manual and labor-intensive process of revenue recognition, ensuring the organization has a clear vision of where it’s been as well as where it’s going.
How can Software Improve the Revenue Recognition Process?
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 the Kantata Cloud for Professional Services™, 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 software like Kantata allows 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, purpose-built software applications reduce the lag time associated with most revenue recognition approval processes. With services technology, 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 Purpose-Built Professional Services Software
1. Automated data collection increases the quality of data inputs
Software that is purpose-built for professional services is designed to close the gap between sales, resourcing, and delivery teams that otherwise tend to become siloed as a business grows. It can be difficult in a growing services organizations to keep all these teams on the same page without one central location and source of truth for updated project statuses and data. These solutions also prompt 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 as reliable and insightful as the currency and accuracy of the input data. Purpose-built professional services software circumvents the issue of data quality by automating the collection of these inputs.
2. 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. The right software can turn the revenue collection and calculation process into an instantaneous process that simply runs in the background. This 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.
3. Automatic re-calibration when changes occur
There are numerous factors that affect the recognition of revenue, and due to the ever-changing nature of the professional 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. The best PSA and Industry Cloud solutions will automatically shift and re-calibrate your revenue when certain inputs are edited. An intelligent software tool will be able to handle change and show you the revenue impact almost immediately.
4. Period close and revenue recognition become more agile
Software plays a key role in enabling services organizations to close down a period and lock in revenue recognition numbers for that period much more quickly than manual methods. Without a purpose-built tool, 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 for which the 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 whether 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.
Purpose-built professional services software ensures 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.