Revenue recognition has been a hot topic for the past several years in light of the release of Accounting Standards Codification (ASC) 606 in 2014. Released by the Financial Accounting Standards Board (FASB) as a part of Generally Accepted Accounting Principles (GAAP) in the U.S., the new guidance standardizes how companies should recognize revenue, particularly in incidents when the nature, certainty and timing of revenue might be complicated.
The International Accounting Standards Board (IASB) then followed suit and released similar guidance as a part of the International Financial Reporting Standards (IFRS) to dictate when that revenue can be considered earned and the financial statement accurately updated.
- What is Revenue Recognition Principle With Example?
- What are the 5 Steps to Establishing Revenue Recognition?
- Why do we Use Revenue Recognition Principle?
- What are the Requirements for Revenue Recognition
- Revenue Recognition Examples
- What are the Methods of Revenue Recognition?
- How do you do Revenue Recognition?
What is Revenue Recognition Principle With Example?
The revenue recognition principle states that you should only record revenue when it has been earned, not when the related cash is collected. For example, a snow plowing service completes the plowing of a company’s parking lot for its standard fee of $100.
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It can recognize the revenue immediately upon completion of the plowing, even if it does not expect payment from the customer for several weeks. This concept is incorporated into the accrual basis of accounting.
A variation on the example is when the same snow plowing service is paid $1,000 in advance to plow a customer’s parking lot over a four-month period. In this case, the service should recognize an increment of the advance payment in each of the four months covered by the agreement, to reflect the pace at which it is earning the payment.
If there is doubt in regard to whether payment will be received from a customer, then the seller should recognize an allowance for doubtful accounts in the amount by which it is expected that the customer will renege on its payment. If there is substantial doubt that any payment will be received, then the company should not recognize any revenue until a payment has been received.
Also under the accrual basis of accounting, if an entity receives payment in advance from a customer, then the entity records this payment as a liability, not as revenue. Only after it has completed all work under the arrangement with the customer can it recognize the payment as revenue.
Under the cash basis of accounting, you should record revenue when a cash payment has been received. For example, using the preceding scenario, the snow plowing service will not recognize revenue until it has received payment from its customer, even though this may be a number of weeks after the plowing service completes all work.
What are the 5 Steps to Establishing Revenue Recognition?
In many industries, there are so many events associated with the revenue recognition process that it can be difficult to establish exactly when revenue should be recognized. Under generally accepted accounting principles, there is a five-step process for establishing revenue recognition, which applies to nearly all industries. Those steps are noted below.
Step 1: Link the Contract with a Specific Customer
The contract is used as a central aspect of revenue recognition because revenue recognition is closely associated with it. In many instances, revenue is recognized at multiple points in time over the duration of a contract, so linking contracts with revenue recognition provides a reasonable framework for establishing the timing and amounts of revenue recognition.
Step 2: Note Contractual Performance Obligations
A performance obligation is essentially the unit of account for the goods or services contractually promised to a customer. The performance obligations in the contract must be clearly identified. This is of considerable importance in recognizing revenue, since revenue is considered to be recognizable when goods or services are transferred to the customer.
Step 3. Determine the Price of the Transaction
This step involves the determination of the transaction price built into the contract. The transaction price is the amount of consideration to be paid by the customer in exchange for its receipt of goods or services. The terms of some contracts may result in a price that can vary, depending on the circumstances.
For example, there may be discounts, rebates, penalties, or performance bonuses in the contract. Or, the customer may have a reasonable expectation that the seller will offer a price concession, based on the seller’s customary business practices, policies, or statements. If so, set the transaction price based on either the most likely amount or the probability-weighted expected value, using whichever method yields that amount of consideration most likely to be paid.
Step 4. Match the Price to Performance Obligations
Once the performance obligations and transaction prices associated with a contract have been identified, the next step is to allocate the transaction prices to the obligations. The basic rule is to allocate that price to a performance obligation that best reflects that amount of consideration to which the seller expects to be entitled when it satisfies each performance obligation.
Step 5. Recognize Revenue as Obligations are Fulfilled
Revenue is to be recognized as goods or services are transferred to the customer. This transference is considered to occur when the customer gains control over the good or service. Indicators that obligations have been fulfilled include when the seller has the right to receive payment, when the customer has legal title to the transferred asset, and when the customer accepts the asset.
Other indicators are when possession of the asset has been transferred by the seller, and when the customer has taken on the significant risks and rewards of ownership related to the asset transferred by the seller.
Why do we Use Revenue Recognition Principle?
In essence, revenue recognition looks to answer when a business has actually earned its money. Typically, revenue is recognized after the performance obligations are considered fulfilled, and the dollar amount is easily measurable to the company. A performance obligation is the promise to provide a “distinct” good or service to a customer. On the surface, it may seem simple, but a performance obligation being considered fulfilled can vary based on a variety of factors.
The revenue recognition principle is a key component of accrual-basis accounting. This accounting method recognizes the revenue once it is considered earned, unlike the alternative cash-basis accounting, which recognizes revenue at the time cash is received. In the case of cash-basis accounting, the revenue recognition principle is not applicable.
Essentially, the revenue recognition principle means that companies’ revenues are recognized when the service or product is considered delivered to the customer — not when the cash is received. Determining what constitutes a transaction can require more time and analysis than one might expect.
In order to accurately recognize revenue, companies must pay attention to the five steps and ensure they are interpreting them correctly. Fortunately, ASC 606 has outlined the Five-Step Model — more on this later.
Proper revenue recognition is imperative because it relates directly to the integrity of a company’s financial reporting. The intent of the guidance around revenue recognition is to standardize the revenue policies used by companies. This standardization allows external entities — like analysts and investors — to easily compare the income statements of different companies in the same industry.
Because revenue is one of the most important measures used by investors to assess a company’s performance, it is crucial that financial statements be consistent and credible.
What are the Requirements for Revenue Recognition
The revenue recognition principle requires that you use double-entry accounting. Here are some additional guidelines that need to be followed in regards to the revenue recognition principle:
- An arrangement or agreement is in place between your business and your customer. What this means is that you have offered credit terms to your customer, and they have agreed to pay the invoice in the amount of time in order to fulfill those terms. For instance, you provide consulting services to Client A, with credit terms of Net 30. If Client A accepts those terms, they agree to pay your invoice within 30 days of the date of the invoice.
- The product or service that you are selling has been delivered or completed. This is one of the most important components of the revenue recognition principle, which is that revenue is recognized and recorded when services are rendered or the product delivered. In essence, this means that your portion of the agreement is complete.
- The cost has been determined. When you offer your services or sell products to clients, you must provide them with the cost of those services or products, with the cost finalized prior to recognizing the revenue.
- The amount billed is collectible. This is fairly straightforward and speaks to the importance of accurately vetting clients to determine their creditworthiness. Before you offer credit terms to clients, you should be reasonably sure that you can collect the balance due from them at a future date. This is not foolproof of course, because even properly vetted companies can pay their bills late at times, but this should be the exception, not the rule.
- If you have doubts about the collectability of an invoice, it should not be recognized as revenue. This is a tough one, since it’s unlikely that you will extend credit terms to a customer that you don’t think will be able to pay their bill. However, if this issue does arise, you should delay recognizing the revenue until the bill has been paid.
- If payment is received in advance of products or services, the revenue should be recognized only after services are rendered. For instance, if your business provides office cleaning services for $500 a month, and your customer pays you $1,500 for the next three months, the revenue would be recognized at $500 for the next three accounting cycles, rather than being recognized in total for the current accounting cycle.
Revenue Recognition Examples
The revenue recognition principle enables your business to show profit and loss accurately since you will be recording revenue when it is earned, not when it is received.
Using the revenue recognition principle also helps with financial projections; allowing your business to accurately project future revenues. Recognizing revenue properly is also important for businesses that receive payment in advance of services, such as businesses that provide service contracts that require payment upfront.
In order to recognize revenue properly, any business that receives payment upfront for services to be rendered must recognize that revenue only after the services have been performed. For instance, if you offer a yearly support contract to your customers for $12,000 annually, you would recognize revenue in the amount of $1,000 monthly for the next 12 months.
Example 1
| Date | Account Name & Description | Debit | Credit |
|---|---|---|---|
| 1/1/2020 | Cash – To record prepayment | $12,000 | |
| 1/1/2020 | Client Prepayment – To record prepayment | $12,000 |
This is to record the initial customer deposit of $12,000.
Example 2
| Date | Account Name & Description | Debit | Credit |
|---|---|---|---|
| 1/31/2020 | Client Prepayment – Record January payment | $1,000 | |
| 1/31/2020 | Account Services Income – Payment for January | $1,000 |
This is to record the January payment since it has now been earned.
In Example 1, you would debit your cash account, since the money will be deposited. However, instead of applying it to an income account, you would place it in a Client Prepayment account, which will be gradually reduced until the complete $12,000 has been earned.
In Example 2, you would debit the Client Prepayment account, since you are reducing the balance by $1,000, while crediting your income account for the month of January, continuing to do a journal entry each month through the month of December in order to properly account for the earned revenue.
Example of the revenue recognition principle
Here are two simple revenue recognition examples:
- Your business provides tax services for a client. Once their tax return has been completed, you forward a copy of your invoice to your client, who has agreed to pay the bill within the next 30 days (net 30). You can recognize the revenue immediately since the services have already been delivered.
- You provide monthly accounting services for your client. That client pays you in advance for the entire year, with payment received on January 2 for the entire year. Remember, you can only recognize revenue as it’s earned, so while you can recognize earned revenue for January, you will have to wait until February in order to recognize February’s revenue, with revenue recognized each month through December, as services are rendered.
What are the Methods of Revenue Recognition?
1. Sales-basis method
Under the sales-basis method, you can recognize revenue at the moment the sale is made. For example, a customer walks into a store and purchases an item. You can recognize that revenue immediately.
You can use this method whether the customer pays with cash, on credit or even has a high likelihood of paying. This method is not dependent on payment, it is the delivery of the goods or services that triggers the revenue recognition event.
Most retail businesses use this method because delivery is immediate and clear, even if payment is not received right away.
2. Completed-Contract method
The completed-contract method allows you to recognize revenue when the entire contract is fulfilled; when all performance obligations have been satisfied. Completed-contract is a good method for shorter contract periods to ensure revenue appears on financials in the correct period. It is not a good method if you are offering extended warranty periods or have a long-term return policy.
Sometimes this method becomes the default for situations where a company cannot recognize revenue on the “percentage of completion” method due to a lack of clarity around performance obligations or when the contract is not enforceable.
3. Installment method
The installment method is generally used for high-ticket purchases (think real estate, home appliances, large machinery) when the reliability of customer payments is not guaranteed. Because the company is unsure about receiving payment, the installment method lets them recognize revenue (as a percentage of total revenue) only when payments are received, which could be over months or years, and often is unexpected.
Most methods allow you to estimate revenue and expenses if you have a high degree of probability that your estimates will be correct. The installment method may be your best bet if you lack knowledge about if or when you will receive payments.
4. Cost-recoverability method
The cost-recovery or -recoverability method is another option when you can’t estimate the likelihood of collection. Use the installment method when you know the related costs and the cost-recoverability method when you don’t know (or can’t estimate) the costs of the goods and services related to the contract.
Under this method, which is the most conservative revenue recognition method, you can recognize revenue only after you have recouped all the costs associated with the contract. That could be long after the contract is otherwise completed and performance obligations have all been satisfied.
5. Percentage of completion method
Commonly used with large or long-term contract agreements, the percentage of completion method allows companies to recognize revenue according to milestones or other indicators of progress. This method requires a detailed contract that delineates each milestone or deliverable to make it clear when revenue recognition may take place.
The percentage of completion method allows you to recognize revenue closer to real-time, rather than waiting until the end of a lengthy contract. Financial statements show a more consistent stream of revenue with fewer large spikes and revenue is more predictable.
How do you do Revenue Recognition?
The joint standards outlined in ASC 606 and IFRS 15 require that companies adhere to a five-step revenue recognition model.
1. Identify the contract or contracts with the customer
To recognize revenue, you must begin by identifying the contract or contracts with the customer. Not all contracts need to be formal and signed to complete this step in the revenue recognition process. Verbal agreements and stated terms and conditions of your service or product can be considered a contract.
There are some key requirements for every contract. It has to be a commercial agreement between two parties where the payment terms, rights, and obligations are clearly stated. A contract can be a formal written agreement, as is often the case with service-based businesses, or a receipt for a point-of-sale purchase at a retail store. With online purchases, terms of service are often embedded within invoices or subscription details, forming a contract.
2. Identify the contract’s specific performance obligations
Before you record revenue, you need to make sure that there’s clarity on your obligations to the customer. The term “performance obligation” refers to a “distinct” product or service that the seller has agreed to deliver.
A “distinct” product or service is usually its own line item on a receipt or an invoice. In the example of a bakery, a specific performance obligation could be the verbal agreement to hand over one pastry in exchange for a set price, rather than the entire order. For an insurance broker, a distinct performance obligation could be one insurance policy for a single house.
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It’s not always that simple, though. A customer must be able to benefit from the product or service separately from the other products or services in the contract. Let’s say that you’re selling a vacuum to a customer. You also sell them an additional warranty for the vacuum, which is its own line item on the receipt. If the warranty can’t be purchased without the vacuum, it isn’t its own “performance obligation.”
3. Determine the transaction price
In addition to the money you’re exchanging with a customer for a good or service, there are also other considerations included in the “transaction price.” It can include the right to return or potential discounts. These terms should always be transparent, especially if there’s been a change from past precedent.
If you offer a discount on e-commerce purchases for your semi-annual sale, that discount is included in the transaction price, as is the right to return or to cancel the contract. For example, if a department store has a clearance sale, the transaction price might cover the following: The customer buys a dress that’s normally $100, but it’s 75% off at a cost of $25 with no returns or refunds.
Typically, people think of refunds in association with physical goods, but defining those terms are just as important in any service or SaaS company. What if people aren’t satisfied with the service? They will want to know what their rights are.
4. Allocate the transaction price to distinct performance obligations
Every business needs to determine the specific selling price connected to each individual performance obligation. Allocating the transaction price is straightforward when there’s a stand-alone selling price for each product or service. When there are various considerations, including discounts, incentives, and rebates, estimate the price based on the expected value.
5. Recognize revenue when you’ve fulfilled each performance obligation
Until your performance obligation is complete, no revenue should be recognized. If your customer has paid you upfront for services not yet completed or goods still in your care, consider the amount “deferred revenue.” Once you’ve transferred control of the good or service to your customer, then you can record the amount as revenue.
For subscription businesses, the performance obligation may be satisfied over a period of time. In that case, you can recognize the revenue evenly throughout the service period. Similarly, there are business models when a service is completed over time but can be measured in other ways: external milestones met, percentage of production completed, costs, or labor hours.
