Who this is for
- Startups whose books count invoices or bank deposits as revenue
- Founders facing a first audit, a financial-statement review or investor diligence
- Corporations and partnerships that prepare accrual-basis financial statements
Not covered here
- Subscription and SaaS deferred revenue schedules
- Tax on customer prepayments and deposits
- What a first audit or review involves
- Switching the tax method from cash to accrual
- Gross versus net revenue for a marketplace
- Detailed accounting for restating statements already issued
- Estimating refunds, returns and usage-based fees in detail
When should a startup recognize revenue under ASC 606?
A startup recognizes revenue when it transfers a promised good or service to the customer, not when it sends an invoice or collects cash. A good transfers when the customer gets control of it, meaning it can direct the item's use and obtain substantially all of its remaining benefits (paragraph 606-10-25-25); a service transfers as the customer receives it. ASC 606 is the US accounting standard for this. It shows revenue as goods or services transfer, in the amount the company expects to be entitled to (FASB summary).
The standard works in five steps (Topic 606, paragraph 606-10-25-1 onward).
| Step | The question | Where the answer sits |
|---|---|---|
| 1. Identify the contract | Is there an approved agreement with identifiable rights and payment terms, and is collection probable? | Signed order form or agreement |
| 2. Identify the promises | Which goods and services were promised, and which are separate deliverables? | Scope of work, product list |
| 3. Set the price | What amount is the company entitled to after discounts, credits and refund rights? | Pricing, discounts, refund terms |
| 4. Split the price | How is the price divided across separate deliverables? | Prices when sold separately |
| 5. Recognize | When does each deliverable transfer to the customer? | Shipping and acceptance records, timesheets, go-live dates |
Delivery alone does not settle it. If a contract fails step 1, for example because collection is not probable, cash received stays a liability, and the company keeps testing whether the contract later passes step 1. Until then the cash becomes revenue only when it is nonrefundable and one of three things has happened: nothing is left to deliver and substantially all the promised cash is in; the contract has ended; or the goods or services it pays for have transferred, transfers have stopped and no further transfer is owed (paragraphs 606-10-25-6 to 25-8, as amended by ASU 2016-12). Under step 3, refunds, returns, credits and usage-based fees make the price variable: the company estimates it and counts only what a later reversal is unlikely to undo (paragraphs 606-10-32-5, 32-6 and 32-11).
A case is not simple when one contract bundles hardware, setup and services; when billing or cash runs ahead of delivery; when the contract has acceptance, refund or usage-based terms; or when investors have already seen revenue built from invoices. If an auditor or investor has asked for revenue under ASC 606, or corrected numbers could differ from figures already shown to investors, that is the point to bring in a professional.
Gather each contract, the invoices and due dates, the cash receipts, proof of delivery or completion, and the revenue policy now in use.
Does a startup have to follow ASC 606, or only when an auditor or investor asks?
A startup follows ASC 606 when it prepares GAAP financial statements. In practice that means when an auditor, investor or lender asks for audited ones. ASC 606 is the revenue rule inside US GAAP. It is an accounting standard, not a tax rule, and an audit opinion on GAAP statements covers revenue under Topic 606.
Books that post bank deposits or invoices straight to revenue may not follow the standard: invoices and delivery sometimes line up and sometimes do not, so each contract has to be tested against it. For what a first audit involves, see audited financials for investors.
Is an invoice revenue, or is revenue recognized when the work is delivered?
Revenue is recognized when the work or product is delivered, not when it is invoiced. An invoice asks for payment. ASC 606 asks whether a promised good or service has transferred to the customer (paragraph 606-10-25-23).
The two match when billing tracks the work, for example a fixed rate per hour worked: revenue can equal the amount the company has a right to invoice when that amount corresponds directly with the value delivered to date (paragraph 606-10-55-18). Amounts collected for third parties, such as some sales taxes, are not revenue at all, and a company may elect to leave out all sales, use and value-added taxes it collects (paragraph 606-10-32-2; paragraph 606-10-32-2A).
A billing export or bank feed is a list of contracts to test, not a revenue report: posting every invoice to revenue overstates it wherever billing runs ahead of delivery.
Cash arrived before delivery: is it deferred revenue or revenue?
Cash received before delivery is not yet revenue. The company owes the customer goods or services, and the standard calls that obligation a contract liability. Revenue is recognized when the goods or services transfer (paragraph 606-10-55-46). Deferred revenue is the usual bookkeeping name; the standard does not prohibit alternative descriptions (paragraph 606-10-45-5).
The liability can also appear before the cash does: when payment is due before delivery and the company's right to it is unconditional, for example because the customer cannot cancel. If the customer can cancel until it pays, nothing is booked until the cash arrives (paragraphs 606-10-55-284 to 55-286). What the books show depends on who has performed (paragraphs 606-10-45-1 to 45-4):
| Situation | Books show |
|---|---|
| Customer has paid, or payment is due and the right to it is unconditional; nothing delivered | A contract liability, no revenue |
| Delivered; only time must pass before payment is due | Revenue and a receivable |
| Delivered; payment depends on something else, such as finishing another deliverable | Revenue and a contract asset (a right to payment that is not yet unconditional) |
| Nothing delivered, no cash received, and payment not yet due or the customer can cancel | No contract asset or liability |
For prepaid subscriptions and monthly schedules, see deferred revenue for SaaS subscriptions. For when a prepayment is taxed, see customer prepayments and deposits.
How does revenue timing differ for hardware, services, milestones and implementation fees?
Timing depends on whether the customer gets control at one moment or gradually. Goods usually transfer at a point in time; services usually transfer over time (FASB summary). The rules are in Topic 606: control indicators (606-10-25-30), services over time (25-27 and 55-5), output and input methods (55-17 and 55-20) and nonrefundable upfront fees (55-50 to 55-53).
| What is sold | When revenue is recognized | What decides it |
|---|---|---|
| Hardware or other goods | When the customer obtains control, not at invoice; a build made to the customer's order can be over time, as in the milestones row | Delivery terms, right to payment, legal title, physical possession, risks and rewards, customer acceptance |
| Services delivered through a term | Over time, as the service is performed | The customer receives and consumes the benefit as the company performs; progress is measured by output or input, such as time elapsed or labor hours |
| Project billed at milestones | When control passes, often as the work progresses, not on the payment schedule | Whether one of three over-time tests is met (paragraph 606-10-25-27): the customer receives and consumes the benefit as the company performs; the work creates or improves an asset the customer controls; or the work has no alternative use to the company and the company has an enforceable right to payment for work done so far. A milestone can be a payment term or a measure of progress, and it sets revenue only if it reflects how much of the work is done |
| Nonrefundable setup or implementation fee | Often as the later service is provided | Whether the fee buys a separate deliverable or only covers setup tasks |
| Subscriptions | Over the subscription term | See the deferred revenue guide above |
One exception for goods: in a bill-and-hold arrangement, the company bills for a product but keeps physical possession of it (paragraph 606-10-55-81). The customer can have control before the product ships, but only if the reason is substantive, the product is identified as the customer's, it is ready to transfer, and the company cannot use it or redirect it (paragraph 606-10-55-83).
When is a contract one deliverable and when several?
A contract has several deliverables when each promise is distinct: the customer can benefit from it alone or with resources readily available, and the promise is separately identifiable within the contract (paragraph 606-10-25-19). Significant customization or integration with other promises, and heavy dependence between promises, point away from separate identification (paragraph 606-10-25-21).
A promise that is not distinct is combined with others until the bundle is distinct, which can mean the whole contract is one deliverable (paragraph 606-10-25-22). Administrative setup tasks that transfer nothing to the customer are not deliverables (paragraph 606-10-25-17).
With several deliverables, the price is generally split in proportion to what each sells for separately. The price printed on the invoice may not be that standalone price (paragraphs 606-10-32-29 and 32-32). Each part is recognized when its own delivery happens. Whether a promise is distinct, and what it sells for on its own, are judgments an auditor is likely to test. Whether revenue is gross or net for a marketplace is a separate question: see gross or net revenue for a marketplace.
How do we fix books that recorded invoices as revenue before the first audit?
Fix them contract by contract, before the audit starts. Books not yet issued as financial statements are corrected in this order:
- List every customer contract and the work performed for the periods the auditor or investors will test. Tie invoices and cash receipts to that list, and flag delivered or partly delivered work that was never billed.
- Match each contract to evidence of delivery: shipping and acceptance records, timesheets, activation or go-live dates.
- Sort each into delivered, partly delivered or not delivered. Delivered amounts are generally revenue in the period of delivery, unless the contract fails step 1 or refund, return, acceptance or credit terms change the price or when the customer got control. Split partly delivered contracts by deliverable. Earned but unbilled work is revenue with a receivable if only time must pass before payment is due, or with a contract asset if something else must happen first (paragraphs 606-10-25-23 and 45-3 to 45-4).
- Move undelivered amounts out of revenue. If the customer has paid, or payment is due and the customer cannot cancel, book a contract liability (deferred revenue). If neither, the amount may not belong on the balance sheet yet (paragraphs 606-10-45-1 to 45-4 and 55-284 to 55-286). Record each correction in the period the revenue belongs to, as a dated adjusting entry with a note of what changed and why, rather than overwriting the original entries, so the auditor can trace it. The chart of accounts needs a deferred revenue account for this.
- Release deferred revenue as delivery happens, using a schedule per contract, then compare corrected revenue by period with what investors or a lender were shown. The differences are the list for the auditor.
Statements already issued to investors or a lender are different. The accounting standard for an error in previously issued statements calls for restating them and disclosing the error (FASB Statement 154, now in Subtopic 250-10). It covers statements issued or available to be issued, meaning complete statements in a form and format that complies with GAAP (FASB Statement 165, now Topic 855). Whether numbers already shown to investors from invoice-based books count, and whether a difference is large enough to restate, is a judgment for the company and its auditor.
Investor and loan documents may also set what the company must report and when: read them, and settle what to tell investors or the lender with the auditor and counsel before sending corrected numbers. A return already filed is not changed by correcting the books; whether it needs changing depends on the tax method, covered next.
How do the books' revenue and the tax return's revenue relate?
They follow separate rules. ASC 606 sets book revenue. The federal tax accounting method sets federal taxable income, and the two can match or differ.
| Tax method | How book revenue connects |
|---|---|
| Cash method | Income is generally taxed when received (26 USC 451(a)); ASC 606 timing does not set tax |
| Accrual method, no applicable financial statement | The all-events test applies: the right to the income is fixed and the amount is known with reasonable accuracy (26 USC 451(b)(1)(C)) |
| Accrual method, with an applicable financial statement | Income is taxed no later than it is revenue in that statement, after the regulation's adjustments. For example, an amount the company could not recover if the customer ended the contract on the last day of the year is left out, unless the company chooses the alternative method that skips that adjustment (26 USC 451(b); 26 CFR 1.451-3(b)(2)) |
An audited GAAP statement used for credit purposes or for reporting to shareholders or partners can be an applicable financial statement; unaudited internal books that are not filed with a regulator are generally not on the list (26 USC 451(b)(3); 26 CFR 1.451-3). So a first audit can change tax timing for an accrual-method startup:
- In a contract with several deliverables, the price allocation in that statement sets the allocation for tax (26 USC 451(b)(4)).
- An accrual-method taxpayer includes an advance payment in income in the year received, or may elect to defer part of it by one year, by filing a return that applies the deferral or, if that changes its method, through the method-change procedures (26 CFR 1.451-8(g)). With such a statement the part kept out of the first year is what is not yet revenue in the statement; without one, it is the part not yet earned (26 USC 451(c); 26 CFR 1.451-8(b) to (d)). How this works is in customer prepayments and deposits.
- If the statement is restated before the return for that year is filed, the restated statement must be used. If using it would change the company's tax method of accounting, it is used only once the IRS permits that method change (26 CFR 1.451-3(a)(5)). A restatement that corrects an error described in 26 CFR 1.446-1(e)(2)(ii)(b) is not a method change (1.451-3(l)(1)); whether a revenue-timing correction qualifies is a judgment for the tax preparer.
Which method a corporation or partnership may use depends on its type and its gross receipts (26 USC 448; Publication 538). To switch, see switching from cash to accrual. For accrual books with a cash-basis return, see accrual books and a cash-basis tax return.
What should we gather and write down for the auditor?
Gather the evidence for each revenue stream, then write down the rules the company applies. The standard requires a private company to disclose its performance obligations (the separate deliverables), when it typically satisfies them, and the judgments that significantly affect the amount and timing of revenue (paragraphs 606-10-50-12 and 50-17; a private company may skip some of the judgment detail under paragraph 606-10-50-21), so an auditor is likely to ask for both.
Gather:
- every customer contract, order form and amendment, with refund, return and credit terms;
- every invoice with its due date, and every cash receipt;
- proof of delivery for each: shipping and acceptance records, timesheets, go-live dates;
- a billing-system export tied to the books' revenue and deferred revenue balances.
Write a one-page revenue policy. For each revenue stream, say what is delivered, when control passes or how progress is measured, how bundled contracts are split, how prepayments, refunds and credits are handled, and who approves exceptions. Investors ask for the same records: see financial records investors ask for in due diligence.
Example
These examples are illustrative. All amounts are in US dollars.
Hardware invoiced in December
A hardware startup invoices $100,000 in December for devices that ship in February, on terms where control passes at delivery. At year end the invoice is not revenue. The books posted it as debit accounts receivable, credit revenue, $100,000. The December 31 correction depends on the contract:
- Paid, or due on a contract the customer cannot cancel: debit revenue and credit deferred revenue, $100,000. In February, when the devices are delivered, debit deferred revenue and credit revenue.
- Unpaid, and either not yet due or cancellable until paid: debit revenue and credit accounts receivable, $100,000. Nothing stays on the balance sheet until the cash arrives or, on a contract the customer cannot cancel, payment falls due; then debit accounts receivable or cash and credit deferred revenue. Delivery in February moves it to revenue.
Either way the $100,000 becomes revenue in February, which is the next year. If the customer had asked the startup to hold the devices and all four bill-and-hold conditions were met, revenue could come earlier.
Consulting billed upfront
A consulting startup bills and collects $60,000 on October 1 for a six-month project delivered evenly, about $10,000 a month.
| Year | Revenue | Contract liability at December 31 |
|---|---|---|
| Year 1 (October to December) | $30,000 | $30,000 |
| Year 2 (January to March) | $30,000 | $0 |
Revenue follows the work month by month. The unearned part sits on the balance sheet.
Setup and support in one contract
A startup signs a $200,000 contract. The invoice shows $150,000 for setup and $50,000 for support. Whether setup is its own deliverable changes the answer.
- If setup is distinct, the price is split by separate selling prices. Suppose the startup sells setup alone for $120,000 and the same support alone for $80,000. Setup gets $120,000 and support gets $80,000, not the invoice's $150,000 and $50,000. Setup is revenue as delivered; support is revenue over the support term.
- If setup is not distinct, the whole $200,000 is one bundle, typically recognized over the service term. That happens if the customer cannot benefit from setup even with other readily available resources, or if significant customization makes setup and support inputs to one combined service. Routine configuration alone does not decide it.
Different for you?
- An auditor or investor has asked for ASC 606 revenue, your books count invoices as revenue, or a restatement could change a number already shown to investors: which contracts are recognized when, how the books are corrected, and how corrected revenue ties to the return are judgment calls that depend on your contracts. See startup accounting help.
- Customers prepay annual or multi-year plans: use deferred revenue for SaaS subscriptions and customer prepayments and deposits for the tax side.
- Your books are accrual but your return is cash-basis, or you are switching: see accrual books and a cash-basis tax return and switching from cash to accrual.
- You are preparing for a first audit: see audited financials for investors.
- You are about to raise and the books are behind: see cleaning up your books before fundraising.
- You run a marketplace or resell others' goods: see gross or net revenue for a marketplace.
Primary sources
- FASB: Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606)
- FASB In Focus: Revenue from Contracts with Customers (Topic 606)
- FASB: Statement 154, Accounting Changes and Error Corrections
- FASB: Statement 165, Subsequent Events
- FASB: Accounting Standards Update 2016-10, Identifying Performance Obligations and Licensing (Topic 606)
- FASB: Accounting Standards Update 2016-12, Narrow-Scope Improvements and Practical Expedients (Topic 606)
- FASB: Accounting Standards Update 2020-10, Codification Improvements (Subtopic 250-10)
- US Code: 26 USC 451, general rule for taxable year of inclusion
- US Code: 26 USC 448, limitation on use of cash method of accounting
- 26 CFR 1.451-3, timing of income inclusion for taxpayers with an applicable financial statement
- 26 CFR 1.451-8, advance payments for goods, services and certain other items
- IRS: Publication 538, Accounting Periods and Methods
About this guide
Published by Cloud Accounting under standing professional approval. This version has no separately recorded personal review. It explains general rules for the tax year shown. It is not advice for your situation.
Changes
- : First published.