A customer just paid you $12,000 for a year of service. It's in the bank, so it's revenue, right? Not yet. Under the accounting rules lenders, investors, and auditors expect, you've earned one month of it. Getting this right matters more as a business grows, takes on investors, or prepares for an audit.
Cash basis vs. accrual basis
Many small businesses keep their books on a cash basis: revenue when money comes in, expenses when money goes out. It's simple, and often fine for a tax return. Accrual accounting records revenue when it's earned and expenses when they're incurred. It gives a truer picture of performance, and lenders, investors, and auditors generally expect it.
The five-step framework
U.S. accounting standards (ASC 606) use five steps to decide when and how much revenue to record:
- Identify the contract with the customer.
- Identify what you've promised to deliver, such as products, services, or access to software.
- Determine the price, including discounts, refunds, or amounts that depend on future events.
- Divide the price among the promises, based on what each would sell for on its own.
- Record revenue as each promise is fulfilled, either at a point in time or gradually over time.
A simple example
A customer pays $12,000 up front for a one-year subscription. On day one, you have $12,000 of cash, but you haven't earned it yet. It's recorded as deferred revenue, a liability, and $1,000 moves to revenue each month as you provide the service. By year-end, all $12,000 has been recognized.
Bundles add a step. If that same deal includes setup work and hardware, the price is split among the pieces, and each is recognized when that piece is delivered.
Why it matters
- Investors compare growth and margins based on recognized revenue, not cash collected.
- Lenders often set loan terms based on accrual financial statements.
- Auditors will test revenue first, because it's where errors most often hide.
- Your own decisions are better when you can see which months and customers actually earned money.
Signs you need a closer look
- You sell annual or multi-year contracts paid up front.
- Your deals bundle products, services, and support.
- You offer usage-based pricing, credits, or refunds.
- You're preparing for a fundraise, an audit, or a sale of the business.
We'd set up a deferred revenue schedule the day the first prepaid contract is signed. Converting years of cash-basis books right before an audit or a raise is a much bigger job.