Earning cash as a business is exciting. However, let’s pump the brakes for a secondbeforeyou immediately recognize that revenue. Has your business actually “earned” thatrevenue?
Revenue recognition has been a hot topic for the past several years in light of the releaseof Accounting Standards Codification (ASC) 606 in 2014. Released by the Financial AccountingStandards Board (FASB) as a part of Generally Accepted Accounting Principles (GAAP) in theU.S., the new guidance standardized how companies should recognize revenue, particularly inincidents when the nature, certainty and timing of revenue might be complicated. TheInternational Accounting Standards Board (IASB) then followed suit and released similarguidance as a part of the International Financial Reporting Standards (IFRS) to dictate whenthat revenue can be considered earned and the financial statement accurately updated.
Curious when your company should recognize its revenue? Read on for the latest and greatestin our comprehensive revenue recognition guide.
What Is Revenue Recognition?
Revenue recognition is an accounting principle that asserts that revenue must be recognizedas it is earned. The focus is on recognizing revenue at the time goods or services aredelivered to customers, as opposed to when payment is made. The principle is regulated bysimilar standards in both the US and internationally, though there are some notabledifferences.
The question becomes: when is revenue considered “earned” by a company? Revenue is generallyrecognized after a critical event occurs, like the product being delivered to the customer.The process involves identifying contracts, fulfilling performance obligations, determiningtransaction prices, and then recording revenue as these obligations are met. This methodaims to promote consistency and transparency in reporting.
Key Takeaways
- Revenue recognition standards can vary based on a company’s accounting method,geographical location, whether they are a public or private entity and other factors.
- The revenue recognition principle, a key feature of accrual-basis accounting, dictatesthat companies recognize revenue as it is earned, not when they receive payment.
- Accurate revenue recognition is essential because it directly affects the integrity andconsistency of a company’s financial reporting.
- In order to standardize processes around revenue recognition, the FASB released ASC 606,which provides a five-step framework for recognizing revenue.
- IASB collaborated with the FASB and issued the similar IFRS 15, Revenue from Contractswith Customers.
Revenue Recognition Explained
In essence, revenue recognition looks to answer when a business has actually earned itsmoney. Typically, revenue is recognized after the performance obligations are consideredfulfilled, and the dollar amount is easily measurable to the company. A performanceobligation is the promise to provide a “distinct” good or service to a customer.On thesurface, it may seem simple, but a performance obligation being considered fulfilled canvary based on a variety of factors.
The revenue recognition principle is a key component of accrual-basisaccounting. This accounting method recognizes the revenue once it is consideredearned, unlike the alternative cash-basis accounting, which recognizes revenue at the timecash 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 arerecognizedwhen the service or product is considered delivered to the customer — not when thecash isreceived. Determining what constitutes a transaction can require more time and analysis thanone might expect. In order to accurately recognize revenue, companies must pay attention tothe five steps and ensure they are interpreting them correctly. Fortunately, ASC 606 hasoutlined the Five-Step Model — more on this later.
Why Is Revenue Recognition Important?
Proper revenue recognition is imperative because it relates directly to the integrity of acompany’s financial reporting. The intent of the guidance around revenue recognitionis tostandardize the revenue policies used by companies. This standardization allows externalentities — like analysts and investors — to easily compare the income statementsofdifferent companies in the same industry. Because revenue is one of the most importantmeasures used by investors to assess a company’s performance, it is crucial thatfinancialstatements be consistent and credible.
Conditions for Revenue Recognition
Conditions for revenue recognition differ based on a company’s geography, businessmodel,whether it is a public or private entity, its bank, investors and numerous other factors.Public companies within the U.S. are required to follow GAAP standards. Whileprivate companies are not technically required to adhere to GAAP, they may find it necessaryfor financing and expansion opportunities.
For some international companies, IFRS comes into play as opposed to GAAP. Many companiesvoluntarily follow IFRS(opens in a new tab) guidelines,but in some 144 countries that have mandated IFRS(opens in a new tab), these accountingpractices are a legal requirement for financial institutions and public companies.
IFRS Reporting Standards Criteria
According to IFRS criteria, the following conditions must be satisfied for revenue to berecognized:
- Risk and rewards have been transferred from seller to the buyer.
- Seller has no control over goods sold.
- The collection of payment from goods or services is reasonably assured.
- Amount of revenue can be reasonably measured.
- Cost of revenue can be reasonably measured.
These criteria fall under three buckets that IFRS list as necessary for a contract to exist:performance, collectability and measurability. The first two criteria listed are classifiedunder “performance.” Performance is achieved when the seller has done most orall of what itis supposed to do to be entitled to payment. The third is a “collectability”condition,which means that the seller must have a reasonable expectation of being paid. The last twoare considered “measurability” conditions because of the matching principle: theseller must be able to match expenses to the revenues it helped earn. Therefore, the amountof revenues and expenses should both be reasonably measurable.
Revenue Recognition Requirements
These revenue recognition standards are required for publicly traded companies. U.S.-basedpublic companies must adhere to GAAP’s revenue recognition standards. Whether privatecompanies are required to follow them is much more complicated.
From a strictly legal perspective, private companies are not required to comply with GAAPstandards in the U.S. However, from a more de facto point of view, companies may need tocomply with revenue recognition requirements for many reasons. Many banks and investorsprefer or even require GAAP-compliant financial reporting, so many companies will find thatthey need to comply with revenue recognition standards to receive any financing. The IFRSfollows a similar approach, where many regions require it for domestic public companies(less so in areas where the rules are still being implemented), but it is a popular optionfor many private companies as well.
Five-Step Model for Recognizing Revenue – ASC 606
While guidance already existed for contracts, the rules varied and were somewhat subjective.In response, FASB issued ASC 606, Revenue in May 2014. The updates aimed to establish someguidance around contracts, as well as some clarity and standardization around the entirerevenue recognition process by replacing different industry and transaction-specificguidelines with a five-step framework:
Identify Contract With Customer:
In order to complete this step, the parties must fulfill several criteria. Allparties must first approve of the contract and be committed to fulfilling theirobligations. The contract will outline each party’s rights as well as thepaymentterms regarding the goods or services to be transferred. It also must have“commercial substance.” This means that both sides expect the futurecash flows of abusiness will change as a result of the transaction. Lastly, collectability must beprobable. This means that payment is likely to be received (i.e., thecustomer’scredit risk should be evaluated at contract inception).
Identify Performance Obligation(s):
In this step, an entity must identify all distinct performance obligations. Aperformance obligation is a promise in a contract to transfer a good or service tothe customer. There are two criteria for a good or service to be considereddistinct, and both of those criteria must be met.
- A good or service is capable of being distinct if the customer can benefit fromit on its own or with other resources that are readily available.
- A good or service must also be separately identifiable from other promises inthe contract to be considered distinct — commonly referred to as being“distinctin the context of the contract.”
Determine Transaction Price:
This part of the process entails determining the amount of consideration the entityexpects to be entitled to, in exchange for transferring promised goods or servicesto a customer (i.e. the transaction price). This does not include amounts collectedon behalf of third parties, like sales tax. In many cases, this step isstraightforward, as the seller will receive a fixed amount of cash simultaneouslywith the transferred goods or services. However, effects from several factors cancomplicate the determination:
- Variable considerations: When there is uncertainty around the amount ofconsideration, like in instances of discounts, rebates, refunds, credits,incentives and similar items.
- Constraining estimates of variable consideration: After estimatingvariable consideration, entities must assess the likelihood and magnitude of thepotential revenue reversal (due to factors like market volatility).
- The existence of a significant financing component: When there is morethan a year between receiving consideration and transferring goods or services,a contract may have a significant financing component. A financing component inthe transaction price considers the time value of money.
- Non-cash considerations: When a consumer pays in the form of goods,services, stock or other non-cash consideration.
- Considerations payable to the customer: Instances where a company mustalso make a payment to a consumer like slotting fees, cooperative advertising,buydowns, price protection, coupons and rebates.
Allocate Transaction to Performance Obligation(s):
If a contract has more than one performance obligation, a company will need toallocate the transaction price to each separate performance obligation based on itsrelative standalone selling price.
Recognize Revenue as Performance Obligation(s) is Satisfied:
The final step is to recognize revenue when or as the performance obligations in thecontract are satisfied.
Transfer of Control: When a customer obtains control over the asset,it is considered transferred and the company’s performance obligationisconsidered satisfied. The company can then recognize that revenue.
Performance Obligations Satisfied Over Time: As a company transferscontrol of a good or service over time, it satisfies the performanceobligation and can recognize revenue over time if one of the followingcriteria is met:
- The customer receives and consumes the benefits provided by theentity’sperformance as the entity performs.
- The entity’s performance creates or enhances an asset (forexample, workin progress) that the customer controls as the asset is created orenhanced.
- The entity’s performance does not create an asset with analternativeuse to the entity (see FASB ASC 606-10-25-28), and the entity has anenforceable right to payment for performance completed to date.
An example of performance obligations being satisfied over time would be aroutine or recurring cleaning service. The customer will receive the benefitof the vendor’s cleaning service as it’s being performedsimultaneously.
Performance Obligations Satisfied at a Point in Time: If aperformance obligation is not satisfied over time, the performanceobligation is satisfied at a point in time. To determine the point in timeat which a customer obtains control of a promised asset and the companysatisfies a performance obligation, it should consider guidance on controland the following indicators of the transfer of control:
- The company has a present right to payment for the asset.
- The customer has legal title to the asset.
- The company has transferred physical possession of the asset.
- The customer has the significant risks and rewards of ownership of theasset.
- The customer has accepted the asset.
For example, an online ecommerce store sends a shirt to a customer. Thatcustomer has 30 days after receipt to return the shirt if needed. Thecompany will consider the performance obligation fulfilled and the 30 dayshas passed.
Measuring Progress Toward Complete Satisfaction of a PerformanceObligation: For each performance obligation satisfied over time, acompany should recognize revenue over time by measuring the progress towardcomplete satisfaction of that performance obligation. Methods for measuringprogress include the following:
Output Method: Outputs are goods or services finished andtransferred to the customer. A company first estimates the amount ofoutputs needed to satisfy the contract. The entity then tracks theprogress toward completion of the contract by measuring outputs todate relative to total estimated outputs needed to satisfy theperformance obligation. Number of products produced or servicesdelivered are both examples of output measures.
Input Method: Inputs are measured by the amount of effortthat has been put into satisfying a contract. The input method isimplemented by first estimating the total inputs required to satisfya performance obligation. The company then compares efforts to datewith the estimated total needed to satisfy the performanceobligation. For example, money, time and materials utilized are allinput measures.
The revenue standard for public companies became effective for annual reporting periodsbeginning after December 15, 2017 for most calendar year-end public business entities and2019 for many non-public business entities. However, in June 2020, the FASB deferred theeffective date for nonpublic entities that had not yet issued, or made available forissuance, their financial statements reflecting the adoption of the standard. For thoseentities, they may elect to adopt the standard for annual reporting periods beginning afterDecember 15, 2019 and interim reporting periods within annual reporting periods beginningafter December 15, 2020. The IASB made its standards listed in IFRS 15 effective financialstatements issued on or after 1 January 2018.
But wait... aren't private companies exempt from complying with GAAP? Yes, they are. Thisdeadline simply means that private companies can still be considered GAAP-compliant by banksand investors using the previous GAAP standards until that date.
GAAP Revenue Recognition Principles
Guidance from the FASB is used to create GAAP principles. Thus, the revenue recognitionprinciple dictated by the FASB ASC 606, a key feature of accrual-basis accounting, is anintegral GAAP principle. It states:
“The core principle of Topic 606 is that an entity should recognize revenue to depictthetransfer of goods or services to customers in an amount that reflects the consideration towhich the entity expects to be entitled in exchange for those goods or services.”
This principle ensures that companies in compliance with GAAP recognize their revenue whenthe service or product is delivered to the customer — not when the cash is received.
However, aside from this principle, previous U.S. GAAP guidance was immensely complicated.There were numerous and inconsistent requirements on how to recognize revenue, differinggreatly across industries and geographies.
This led the FASB to release the update to ASC 606, which replaced GAAP’s 100 differentindustry and transaction-specific guidelines with a basic, five-step framework. Its intentis to provide more information on how to handle revenue recognition in contractualsituations and offer an industry-neutral framework for improved comparability of financialstatements.
The IASB soon followed suit and issued IFRS 15, Revenue from Contracts with Customers. Thesestandards have essentially achieved convergence between the U.S. GAAP and the IFRS(opens in a new tab), with onlysome minor differences.
For companies of all sizes, both public and private, revenue recognition is an importantconcept to understand fully. It is critical for businesses to look strategically at revenuerecognition policies to ensure they are compliant now and are conducive to thecompany’sfuture financing, filing and expansion goals.
To that end, advanced financialmanagement software will help you schedule, calculate and present revenue on yourfinancial statements accurately, automating revenue forecasting, allocation, recognition,reclassification, and auditing through a rule-based event handling framework — whetheryourbusiness conducts sales transactions that consist of products or services, or both, and,whether these transactions occur at a single point in time or across different milestones.
Revenue Recognition Examples
To better understand revenue recognition, let’s walk through two examples of companieswithdifferent business models.
Example: Subscription Service
The popularization of the subscription model presented some revenue recognitionchallenges. Instead of a one-time transaction, subscription models presented avariety of ways to pay – annual, quarterly, monthly, etc. With differentstandardsexisting dependent on industry, the FASB decided to standardize the process byintroducing ASC 606, which provided guidance and a five-step model for recognizingrevenue. These steps are used to identify specific contractual obligations withtheir associated pricing and to define how revenue will be recognized.
For example, a coffee subscription company charges $25 a month to send a sampling ofground coffees to its subscribers. It also charges a one-time $50 startup fee forthe process of learning more about the consumer, creating a curated selection ofcoffees and sending a pour-over coffee maker as a part of the subscription program.
Once the initial process is complete (i.e., the consumer has completed thequestionnaire, the company has created a curated plan and the pour-over coffee makerhas been delivered), that $50 can be recognized. The recurring fee, however, ischarged on the first of each month even though the coffee itself is not delivereduntil mid-month. The company cannot recognize that $25 recurring payment when theyreceive it, as the business has not technically earned it yet.
Account Debit Credit Account Receivable $75 Earned Revenue $50 Deferred Revenue $25 Because the startup process has been completed, that revenue can be recognized asearned. However, since the monthly service has not yet been delivered, theaccounting ledger must reflect that. Thus, the revenue is deferred.
At the end of the month, when the business has delivered both the startup process andthe monthly service, the ledger can be updated to reflect the newly recognizedrevenue.
Account Debit Credit Deferred Revenue $25 EarnedEarned Revenue $25 Let’s look at another relevant situation here. A current consumer decides toopt intothe annual coffee subscription plan, meaning that they pay for 12 months of theservice at a discounted upfront cost of $264 ($22/month). The coffee company cannotrecognize that $264 upfront, as it has not delivered the service/product. Instead,the business will recognize the $22 each month after the consumer receives theircoffee sampler.
Example: Independent Contractors
Independent contractors also face a perplexing accounting situation, because whenthey are paid often varies.
As an example, let’s say an independent digital design agency is hired by astartup.The startup agrees to pay the contractor for three performance obligations: websitecreation, logo design and digital ads ($12,000, $4,500 and $3,500, respectively).The agency will be paid after each product is delivered.
The digital design company’s ledger, because it has not earned the revenue yet,wouldfirst display as such:
Account Debit Credit Account Receivable $20,000 Deferred Revenue (liability) — Performance obligation A(Website) $12,000 Deferred Revenue (liability) — Performance obligation B(Logos) $4,500 Deferred Revenue (liability) — Performance obligation C(Digitalads) $3,500 The agency completes and delivers the website in the first month, leading to a ledgerupdate – even if they have not been technically paid by the client yet. Assoon asit’s delivered, the performance obligation is considered fulfilled.
Account Debit Credit Deferred Revenue (liability) — Performance obligation A(Website) $12,000 Earned Revenue — Performance obligation A (Website) $12,000 In the following month, it finishes and delivers the logo designs.
Account Debit Credit Deferred Revenue (liability) — Performance obligation B(Logos) $4,500 Earned Revenue — Performance obligation B (Logos) $4,500 Deferred Revenue (liability) — Performance obligation B(Logos) $4,500 Deferred Revenue (liability) — Performance obligation C(Digitalads) $3,500 In the third month, the digital ads are done and delivered, so the agency hasfulfilled its performance obligations. Thus, the remaining revenue can berecognized. Again, this can be recognized even if the startup hasn’ttechnicallypaid them yet. The performance obligations have been fulfilled, meaning the revenuecan be recognized.
Account Debit Credit Deferred Revenue (liability) — Performance obligation C(Digitalads) $3,500 Earned Revenue — Performance obligation C (Digital ads) $3,500
Understanding and applying the principles of revenue recognition is crucial for maintainingthe integrity and consistency of a company's financial reporting. The establishment of ASC606 and IFRS 15 standards has been a significant stride toward standardizing revenuerecognition practices across the globe, ensuring transparency and comparability amongbusinesses. As businesses navigate the complexities of revenue recognition, they must stayinformed and compliant with these standards to accurately depict their financial health andperformance. This guide serves as a comprehensive resource for mastering the intricacies ofrevenue recognition, aiding companies in their journey toward financial precision andreliability.
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Tailored to adapt to the complexities and regulations of modern financial environments,NetSuite’s Cloud Accounting Software automates and simplifies the revenue recognitionprocess, ensuring compliance with USA and international standards. Whether your businessdeals with products, services, or a combination of both, across single or multiplemilestones, NetSuite provides a rule-based event handling framework that meticulouslyschedules, calculates, and presents your revenue. This not only enhances the accuracy ofyour financial statements but also optimizes revenue forecasting, allocation, recognition,reclassification, and auditing. Elevate your business with NetSuite's accounting softwareand embrace a future of financial clarity and compliance. Discover how NetSuite cantransform your revenue recognition practices and propel your business towards unprecedentedgrowth and success.
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Revenue Recognition FAQs
Do small businesses need to understand revenue recognition?
Small businesses do need to understand revenue recognition and its associated principles.Even though many smaller companies are private and therefore not required to follow GAAP,many still adhere to the standard. From a financing perspective, GAAP financial statementsare commonly understood by lenders and investors, providing credibility to the financialreporting and the company as a whole. Thus, having GAAP-compliant revenue recognitionpractices and financial statements can open up more financing options and sources, often ata lower cost — making it easier to build and expand a business.
For companies that are considering going public eventually, already adhering to GAAP can helpease the transition. When a private company goes public, the company will have a differentownership and capital structure, investors with varying investment strategies, generallymore accounting resources and limited investor access to management. Therefore, the companymust immediately meet the regulatory requirements in which it is filing, which may includesubmitting GAAP financial statements with the U.S. Securities and Exchange Commission (SEC).
How does revenue recognition help my business?
Revenue recognition isn’t just for compliance purposes — it is of benefit forcompanies torecognize revenue in a consistent manner, as well. Internally, companies can review andcompare their current financials with past ones without qualm, knowing that their revenuerecognition policies have remained consistent. Following the standards for revenuerecognition also allows for easy external comparison so businesses can quickly and easilygauge how they are performing relative to their competitors.
