Revenue earned over time needs to be accounted for correctly. As a general rule, you have two choices about when to record revenue: If you record revenue when you invoice a customer, you’re using the accrual method. If you account for the revenue when you collect the money from your customer, you’re using the more common cash method.
Small companies tend to use the cash basis of accounting because it takes the sting out of paying income tax; you’re only taxed on the money you receive, not when you invoice the customer for finished work.
Recognizing when your business has made a sale seems simple enough; you really just need to decide whether to use the accrual or cash method of accounting. Unfortunately, accounting is not always so simple. Both large and small companies can be significantly impacted in situations where the money received is not connected to the time it’s actually earned.
Two common manifestations of this issue are: multiple deliverable arrangements and gift cards.
Multiple deliverable arrangements
Even a solopreneur may make sales with stipulations about warranties, maintenance contracts, and pre-paid deposits securing future installations.
These are multiple deliverable arrangements (MDAs) because they entail collection of funds that haven’t yet been earned; the money is actually unrealized revenue.
It’s considered a liability because you’re committing to completing additional work or issuing refunds if the situation requires it. It only becomes revenue when specific contractual terms occur, such as equipment ordering, scheduled installation, or the arrival of an expiration date.
Whatever the conditions of sale under an MDA, you’re confronted with recognizing income over time. This means you have to implement a system to transfer the initial liability to revenue. Deciding when revenue is earned on MDAs is a challenge. Discuss this topic with your accountant to come up with simple rules that periodically recognize a percentage of MDA liability as revenue.
Another example of collecting money that is viewed as a liability occurs with gift cards; you’re obligated to honor the gift card through a sale that takes place sometime in the future. Tax rules dictate that some percentage of gift card sales is recognized as revenue in the year the money is collected. The remainder is treated as revenue in the next year for tax purposes.
How much of the payment is earned in the first year depends largely on your type of business. Gift cards with specified expiration dates and identifiable tracking information are easy revenue decisions. Complications occur when payment is received for general tokens that don’t expire and aren’t separately tracked.
In these cases you are permitted to use any reasonable method of accounting for revenue. For instance, a ratio of sold tokens to redeemed tokens establishes a statistical relationship that demonstrates the appropriate percentage of tokens sold to count as revenue in the year of sale.
However, as with MDAs, it’s crucial for you to work with your accountant, who can advise you on how to account for gift card revenue.