Revenue transactions occur continuously throughout the lifetime of a business. However, since the business prepares financial statements on a periodic basis the transactions need to be allocated to a particular accounting period. Revenue recognition accounting refers to the process of identifying the timing and amount of consideration that a business should record in its income statement as revenue from the sale of goods or services.
Revenue Recognition Conditions
Revenue recognition is based on a core principle that revenue is recognized when goods or services are transferred to the customer, and the amount recorded reflects the consideration the business expects to receive in exchange for the goods or services transferred.
For example suppose a business receives an order from a customer for one of its products, the business processes the order and dispatches the product to the customer and the customer pays at a later date.
Using the core principle, until the product has been transferred (delivered) to the customer no revenue can be recognized. When the products are transferred to the customer the business can recognize the revenue and the amount of revenue recognized will depend on the amount of goods transferred (in this case the value of the order).
It should be noted that the receipt of cash is not an indicator of revenue recognition. The customer in the above example might have paid cash in advance to secure the order but until the goods or services are transferred to the customer no revenue can be recognized.
5 Step Revenue Recognition Model
In the simple example described above the core principle of revenue recognition is easily applied. It is very clear when the goods were transferred to the customer and that the amount of revenue earned was the total value of the goods transferred.
In most situations the point at which revenue can be recognized is not as clear and the new standard uses a five step revenue recognition model in applying the core principle.
The 5 revenue recognition steps are as follows.
- Identify the contract
- Identify performance obligations
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue
Step 1: Identify the Contract
The first step is to identify the contract between the business and its customer. The contract can be written, oral, or implied but must be legally enforceable and satisfy the following criteria.
- Each party approves the contract
- Each party’s rights are identified
- Payment terms are identified
- The contract has commercial substance
- The collection of the consideration is probable
If the criteria are not met then the consideration received from the customer is normally treated as a deposit liability and not recognized as revenue.
Step 2: Identify Performance Obligations
Performance obligations in the contract are promises by the business to transfer distinct goods or services to the customer.
For example the performance obligation in a simple purchase contract might be to deliver 2,000 units of product to the customer.
More complicated contracts will have multiple performance obligations and the purpose of identifying them is to allow revenue to be recognized as each obligation is satisfied.
Step 3: Determine the Transaction Price
The transaction price is the amount of consideration the business expects from the customer for goods or services transferred.
In a simple contract the transaction price might be fixed, for example 2,000 units at 4.00 gives a fixed transaction price of 8,000.
In the five step revenue model the transaction price is not necessarily fixed and its calculation needs to take into consideration the following.
- Variable consideration components such as discounts, rebates, refunds, or performance incentives which need to be estimated.
- The fair value of any non-cash consideration.
- Consideration payable to the customer by the business such as, for example, amounts due in respect of credits.
- Financing components when here is a significant time period between payment and transfer of the goods or services.
Step 4: Allocate the Transaction Price
The next step is to allocate the transaction price (step 3) to each of the performance obligations (step 2) in proportion to the price at which each obligation would have been sold separately (referred to as the stand alone selling price).
Step 5: Recognize Revenue
Revenue is recognized when the business satisfies each obligation by transferring control of the goods or services to the customer.
It should be noted that the satisfying of performance obligations and therefore revenue recognition can occur at a single point in time such as, for example, the physical delivery of goods to a customer, or over time such as, for example, the provision of recurring maintenance services, or the construction of an asset for the customer.
The new 5 step revenue recognition model might have little impact on the timing and amount of revenue recognized for simple contracts with a single deliverable performance obligation; however, it might significantly affect revenue recognition for many businesses whose contracts include more complex arrangements.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.