Revenue Recognition

Written By:
Adiste Mae

Revenue recognition… sounds like a job for the accountant and his/her accounting staff huh?

Well, yes, but not entirely.

Yes, because it is the accounting department’s responsibility to report a business’s revenue in its books and financial statements.

But only partially yes, because revenue recognition is not their responsibility alone.

For revenue to be reported in the first place, there must be actual revenue to be recorded which is mostly the responsibility of the sales team.

Before there is actual revenue, there must be a product to sell which is the responsibility of the production/manufacturing team and/or the purchasing team.

Before there are products to be produced, there must be funds to be able to purchase the products or materials needed to produce such products which is the responsibility of the investors.

You get the point right?

Yes, recognizing revenue and reporting it on the business’s books and financial statements is the responsibility of the accountant and his/her team, but revenue is the responsibility of everyone involved in the business.

That includes you as the owner.

Unless your business is formed for a non-profit purpose, its main function is to generate profit.

And where does that profit come from?

Why, it comes from the revenue that your business makes.

The relationship between the two can even be found on your business’s income statement.

Revenue is your top line, while net income or net profit is your bottom line.

The question now is when and how revenue is recognized.

Do you recognize it when you receive payment?

Do you recognize it when a product reaches the customer’s hand?

Do you recognize it when a service is completed?

Do you recognize it at a certain level of completion?

Do you recognize it once a certain period has passed?

In this article, we will know what revenue recognition is and the principle behind it.

While it’s easy to leave this to your accountant, gaining knowledge on how the revenue generated by your business is recognized can help you in making business decisions.

What is Revenue Recognition?

Revenue recognition is a generally accepted accounting principle (GAAP) the provides us with certain conditions in which revenue should be recognized.

It also determines how to account for such revenue.

For example, under the cash accounting method, revenue is recognized when cash is received.

Under the US GAAP which requires the accrual accounting method for recording income and expenses, revenue is recognized when it is earned and that its dollar amount can be reliably accounted for.

But when and how is revenue exactly earned?

For a business to stay in existence, it would need, at the very least, enough revenue to sustain its operations.

And because of that, businesses might be tempted to stretch the definition of revenue, recognizing them when they shouldn’t be.

This is especially obvious when revenue is recognized even if it is not yet completely earned.

This is why regulatory bodies such as the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) regularly release guidelines to standardize the recognition of revenue.

The complexity of revenue recognition depends on the nature of the business.

For example, in a retail store setting where the customer directly pays for a product s/he purchased, then revenue recognition is simple.

You recognize revenue when a sale is made, which is the time when the customer receives his/her product.

In a construction company setting however, revenue recognition can be complicated.

Since it’s unreasonable to expect a major construction to be completed within a day, recognizing revenue in the same way as retail stores do is not an option.

The issue now is when to recognize revenue in such a situation.

Does the construction company only recognize it when construction is complete?

That can be a problem if construction lasts for several periods. It might understate or overstate their income in certain periods.

Does the construction company recognize revenue when it receives payment?

That can be a problem if payment is received before construction begins, and it does not follow the accrual accounting method.

Who knew revenue recognition could get this complicated huh?

Thankfully, Financial Accounting Standards Board (FASB), as well as the International Accounting Standards Board (IASB) recently released a set of guidelines related to revenue recognition.

The FASB issued ASC 606 titled Revenue from Contracts with Customers.

The IASB released IRFS 15 which is also titled Revenue from Contracts with Customers for businesses that operate outside of the US.

Directly quoted from the FASB website, ASC 606 aims to do the following:

• Removes inconsistencies and weaknesses in existing revenue requirements
• Provides a more robust framework for addressing revenue issues
• Improves comparability of revenue recognition practices across entities, industries, jurisdiction, and capital markets
• Provides more useful information to users of financial statements through improved disclosure requirements
• Simplifies the preparation of financial statements by reducing the number of requirements to which an organization must refer

With the release of these guidelines, there is at least some sort of uniformity in regards to revenue recognition whatever industry the business is in.

This is a godsend for accountants and analysts who constantly deal with financial reporting and financial statements.

Revenue from Contracts with Customers

Developed by the FASB and IASB, ASC 606 Revenue from Contracts with Customers provides businesses with a framework to drive consistency in financial reporting.

It also aims to improve comparative analysis and reporting, as well as simplify the preparation of financial statements.

It does all this by providing us with a 5 step model for revenue recognition.

Essentially, revenue recognition can be broken down into five steps:

1. Identify the contract with a customer
2. Identify the performance obligation/s in the contract
3. Determine the transaction price
4. Allocate the transaction price to each performance obligation
5. Recognize revenue when a performance obligation is fulfilled

Identify the contract with a customer

To complete this step, the parties involved in the transaction have to fulfill certain criteria.

All parties must be amenable to the contract and be committed to fulfilling their part in it.

Ideally, the rights and expectations of each party are stated on the contract.

It must have commercial substance, meaning that fulfillment of the contract will have an effect on the cash flows of each involved party.

Lastly, collectability must be probable, meaning that that performing party can reliably expect to receive payment for the fulfillment of the contract.

Identify the performance obligation/s in the contract

In this step, the performing party must identify all distinct performance obligations as much as possible.

Performance obligation refers to the promise in a contract to transfer a good or service to a customer.

For a good or service to be considered distinct, it must meet the following criteria:

1. A customer can benefit from it on its own or with other readily available resources
2. It is or can be separately identifiable from other promises in the contract

For example, if it was stated in the contract the performing party is to transfer the ownership of a car plus a complimentary 1-week driving lesson, then the performance obligations in such a contract are: (1) the transfer of ownership of the car, and (2) the fulfillment of the 1-week driving lesson.

Determine the transaction price

In this step, we determine the amount of compensation the performing party expects to receive after the fulfillment of the performance obligation/s.

The amount collected on behalf of third parties such as sales tax or withholding taxes is not included in the determination of transaction price.

The compensation is usually in the form of cash, but it can be in the form of non-cash assets too.

Several factors can complicate the determination of the transaction price such as discounts, returns, credits, incentives, etc.

Allocate the transaction price to each performance obligation

This step is only necessary if there is more than one performance obligation to be fulfilled by the performing party.

In this step, we allocate the transaction price to each identifiable performance obligation.

The allocation is based on the relative standalone selling price of each performance obligation.

Let’s go back to the car sale example above.

The transaction price of the whole contract is $30,000.

Assuming that the car has a standalone price of $30,000 and the 1-week driving lesson has a standalone price of $500, the allocation would be:

Recognize revenue when a performance obligation is fulfilled

The final step is to recognize revenue.

Typically, only when a performance obligation is fulfilled should revenue be recognized.

When exactly a performance obligation is fulfilled depends on the nature of the business.

There are several methods of determining when a performance obligation is fulfilled, with the following as common examples:

• Sales-based method – under this method, a performance obligation is considered fulfilled when both parties agree to the terms of the contract, and that the performing party (seller) has transferred the ownership of goods to the receiving (buyer) party. This method is typically used for businesses that sell goods/products that are pre-produced such as a convenience store.
• Completed-contract method – under this method, a performance obligation is considered as fulfilled only if the contract is fully executed. This method is typically used by businesses that perform short-term services such as a software company, or a handyman company.
• Installment method  – under this method, a performance obligation is considered fulfilled in the same way as the sales-based method or completed-contract method. However, the recognition of revenue is different. Revenue is only recognized if the business is expecting to receive payments. This is applicable for businesses that have a lot of credit sales.
• Percentage-of-completion method – under this method, revenue is recognized at certain levels of completion. This is different from the previous three methods that only recognize revenue if a performance obligation(s) is fulfilled. This is typically used by businesses that have contracts that span several periods such as construction companies. Revenue recognition is based on the percentage of work done. The percentage can be determined in different ways such as matching the costs already incurred or basing it on the actual physical form of the asset to be delivered.

Revenue recognition and small businesses

Since a bulk of small businesses employ the cash accounting method, they might not feel the need to comply with ASC 606 or even just learn about it.

However, every business (be it private or public), including small businesses, must understand revenue recognition and its associated principles.

Even if they’re not required to follow the US GAAP or IFRS, creditors such as banks and other financial institutions may require financial statements that adhere to the US GAAP before granting a loan.

Plus, outside investors will usually have more confidence in financial statements that are adherent to the US GAAP.

A business that has GAAP-compliant revenue recognition practices will usually have more financing options compared to a business that doesn’t.

It also makes the process of going public easier.

Public companies are usually required to have GAAP-compliant financial statements.

So if your business’s financial statements already adhere to the US GAAP, you’ll have one less thing to worry about.

In general, knowing when to recognize revenue will help you and your business.

Having a consistent manner of recognizing revenue will it make easier for you and your management to set KPIs and sales targets. Comparing your business’s current performance to past performance will also be easier because of the uniform revenue recognition.

The same applies to comparison with other businesses within the same industry.

This makes it easy for a business to gauge its financial performance and health relative to its competitors.

Besides, wouldn’t you want to know how your business earns its profit?

Having knowledge of your business’s revenue recognition can help you with that.