Revenue recognition is the five-step process that businesses must follow to recognize revenue properly. It starts with identifying contracts with customers and ends with revenue recognition.
What Is Revenue Recognition? 5-step Model & Best Practices
This article is part of a larger series on Bookkeeping.
Knowing what revenue recognition is and its importance in financial reporting helps businesses make informed decisions and have a clear picture of business performance and financial health. To help you recognize revenue properly, we’ll borrow the five-step model from ASC 606, which determines the GAAP
Generally Accepted Accounting Principles
for revenue recognition. Even if your business isn’t required to comply with GAAP, it’s good practice to follow the standards for proper revenue recognition to provide a useful picture of your profitability from period to period.
Key Takeaways
- The five steps in revenue recognition:
- Identify the contract with the customer
- Identify the performance obligations
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue
- Revenue recognition in the GAAP is not the same as with tax. You must still reconcile financial income with taxable income.
- For small businesses, full compliance with GAAP revenue recognition standards isn’t required.
- Properly recognizing revenue is a must regardless of business size. Resulting in unethical practices is highly discouraged.
The 5-step Model of Revenue Recognition
The five-step model of revenue recognition originates from IFRS 15 Revenue From Contracts With Customers. It is an international standard developed by the International Accounting Standards Board (IASB). The Financial Accounting Standards Board (FASB)—the promulgator of the US GAAP—later on adopted the international standard as ASC 606 to have uniformity in revenue recognition.
Step 1. Identify the Contract With the Customer
In revenue recognition, contracts A contract is an agreement that creates an obligation to all parties bound by it. can be oral or written. However, a contract’s formality (i.e., whether it should be in writing) depends on the jurisdiction.
It’s best to seek legal advice to determine which type of contract needs to be in writing to be legally enforceable.
As far as revenue recognition principles are concerned, contracts must possess the following characteristics:
- There is consent to the stipulations stated in the contract;
- The rights (i.e., ownership) towards the goods agreed upon in the contract are clearly defined;
- The payment for the delivery of the goods is clearly defined;
- The contract has commercial substance According to ASC 606, a contract has commercial substance if 'the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract.' In other words, the contract must have a noticeable effect on the business operations. and
- The collection of the payment is reasonably assured Reasonable assurance means that the company is confident that it will collect the payment from the customer and that there are no doubts about the customer's ability to pay. .
Issues With Contracts
- Supply agreements: Suppose you entered into an agreement with a company to be your exclusive supplier of raw materials. While the supply agreement is also a form of contract, it is merely an agreement to be an exclusive supplier, not a contract to deliver goods to you. For purposes of Step 1 of the five-step model, supply agreements are not considered a contract with a customer.
- Free trials: A free trial is an incentive given to customers who would like to try your product. Giving free trials doesn’t constitute a contract with a customer—it’s merely allowing customers to try your product for free for a specified period. There is no contract when giving a free trial.
- Contract to sell: A contract to sell allows someone else to sell your product on your behalf and is not a contract with a customer; therefore, it cannot be used to recognize revenue. This type of contract is common for distributors or sales agents. A contract to sell is not a contract with a customer.
Combined Contracts
Since revenue recognition depends on a per-contract basis, it’s important to distinguish between separate contracts and combined contracts. Separate contracts can be combined into one if they satisfy all of the requirements below:
- The contracts were entered into at the same time
- The contracts were negotiated as a package
- The contracts are interconnected with each other
- The goods or services are a single performance obligation
A construction company offered a package to (1) build a 10-story building for $10 million; and (2) provide building maintenance services for the next six years priced at $50,000 per year. Technically, the contract to construct the building is separate from the maintenance services. However, since the construction company offered it at the same time in a package, the two contracts can be combined into one for revenue recognition purposes.
Step 2. Identify the Performance Obligations
A customer contract can have several performance obligations A performance obligation is the basis of measuring revenue. and determining each performance obligation is essential to identify obligations before recognizing revenue.
Examples of performance obligations are as follows:
- Consulting company: Offer marketing consultancy services to a client for six months
- Meat dealer: Deliver 2,000 pounds of pork
- Professional singer: Perform five song numbers in an intimate event
- Artist: Make a logo for the client
A performance obligation must be distinct from other obligations. If it’s not distinct—meaning that the customer can benefit from the product alone or can resell it to third parties—then you should combine it with other performance obligations.
Company A sells smartphones. Each purchase comes with the phone, charging brick, and USB cord. It also includes freebies, such as wireless earbuds and a power bank.
In this scenario, the phone, brick, and USB cord are not distinct because these items are interconnected with each other—one can’t use a phone without a charger and a charger without a phone. On the other hand, the wireless earbuds and the power bank are distinct because they can be used on their own. Moreover, the buyer can resell them if they don’t need them.
Step 3. Determine the Transaction Price
The transaction price The transaction price is the amount that you expect to receive for providing goods or services to the customer. must be clearly stated in the contract, whether it’s paid for by cash or with another asset. When you ask for a down payment, that’s considered part of the transaction price since it’s a partial payment for goods and services purchased.
Variable Considerations
Sometimes, it is hard to determine the exact transaction price because its final value relies on a condition. Discounts, bonuses, penalties, and rebates are examples of undertakings that may result in a variable consideration.
Revenue recognition guidelines state that in the event of a variable consideration, you must use the expected value approach or the most likely amount in estimating the amount of variable consideration. The expected value is the sum of all probability-weighted amounts while a most likely amount is a single value that you reasonably estimate to be the closest value to the actual cost.
Company A enters into a contract with Company B to construct a new building for $200,000. Company A agreed that if the project is completed two months in advance, Company B will receive a bonus of $10,000. If it finishes the project one month in advance, Company B will receive a $5,000 bonus.
For this scenario, Company B must estimate the variable consideration by using past experience and estimates. Let’s assume the following assumptions:
- 40% confident that it will complete the project two months in advance
- 60% confident that it will complete the project one month in advance
The variable consideration in this matter should be $7,000, given [($10,000 × 40%) + ($5,000 × 60%)].
Step 4. Allocate the Transaction Price
The fourth step is allocating the transaction price based on the performance obligations. Allocation is based on the stand-alone selling price (SASP) of each product or the price of the product if purchased separately.
The formula for computing the allocated price is
Allocation per Performance Obligation = (SASP ÷ Total SASP) × Transaction Price
Yippy Company is an event organizer. It recently closed a birthday party package for $6,000, which includes the party host, a photo booth, catering, and tables and chairs. Here are the prices of Yippy’s services if purchased individually:
- Party host: $1,000
- Catering: $2,000
- Tables and chairs: $500
- Photo booth: $1,500
- Photographer: $1,000
The transaction price calculation is shown below:
Individual Service | SASP | % | Transaction Price | Allocation |
|---|---|---|---|---|
Party host | $1,000 | $5,000 | ||
Catering | $2,000 | $5,000 | ||
Tables and chairs | $500 | $5,000 | ||
Photo booth | $1,500 | $5,000 | ||
Photographer | $1,000 | $5,000 | ||
Total | $6,000 | 100% | $5,000 |
The transaction price allocation per performance obligation will be recognized as revenue in Step 5.
Step 5. Recognize Revenue
The last step of the five-step model is to recognize revenue. There are two ways to recognize revenue.
- Over time: Revenue is recognized over time if it satisfies at least one of the following conditions:
- The customer simultaneously receives the products or service as it is being performed (e.g., monthly bookkeeping services and cleaning services).
- You continuously enhance or create the product that the customer controls (e.g., bookkeeping services and website-building services).
- The product being created or performed has no alternative use to you and it cannot be sold to another (e.g., uniforms designed specifically for a company).
- At a point in time: Revenue is recognized at a point in time when the customer has already received the asset and has full control over it.
If revenue can’t be recognized over time, it goes without saying that it is recognized at a point in time.
Revenue recognition for GAAP or book reporting doesn’t apply to income tax accounting. Revenue for books and tax can be recognized in different periods.
There are two major methods of recognizing revenue over time. One method is based on your input into fulfilling the contract, while the other is based on the actual output you’ve achieved.
Input | Output | |
|---|---|---|
Basis | The efforts and resources you have expended to fulfill the obligation, relative to the total expected or estimated inputs | The actual measurements and final results of the work performed |
Examples | Hours worked, costs incurred, and machine hours | Area covered (e.g., hectares), time spent, and milestones achieved
|
Under the input method, the most common measure used is costs incurred. Revenue recognition over time often uses the percentage of completion method (PCM), especially in long-term construction contracts. Aside from PCM, there are also other methods like the completed contract method (CCM) and cost recovery method (CRM). Below is a comparison of the three input methods:
PCM | CCM | CRM | |
|---|---|---|---|
Recognizes Revenue | Yes, based on the completion percent | Yes, at the end of the contract | Yes, only up to the extent of costs |
Recognizes Expenses | Yes, based on actual expenses incurred | Yes, at the end of the contract | Yes, based on actual expenses incurred |
Recognizes Net Income | Yes, based on the completion percent | Yes, at the end of the contract | No, unless it exceeds and recovers total costs |
Importance of Proper Revenue Recognition
Properly recognizing revenue requires a lot of work, but doing so brings a lot of useful information to the business. This information can help with making informed decisions based on accurate and truthful revenue data.
- Aids in performance evaluation: Revenue is a key performance indicator (KPI) of performance. Proper revenue recognition enables management to evaluate business performance accurately without bias or prejudice. It helps the business forecast revenues, track growth, detect trends, and assess revenue-generating capabilities.
- Boosts investor and lender confidence: Infusing additional capital into the business can be hard, as investors and lenders need to be convinced why they should invest. Recognizing revenue properly enables you to showcase your business’s true potential in driving growth. If you are falsifying revenue numbers, investors and lenders will lose confidence and back out.
- Provides reliable information for decision-making: Revenue recognition is not 100% an exact science—a lot of estimations are involved due to the complexities surrounding customer contracts. If you recognize revenue honestly, the information you get from sales and income reports can help you make decisions for the future. It can help you gauge if the business can sustain the additional burden of significant business decisions.
Revenue Recognition Best Practices for Small Business
Though revenue recognition is meticulous and procedural, it can be simplified for small business applications. Below are some best practices that you can follow:
- Put a contract in writing if it is a big project or purchase: If you enter into big projects or purchases, ask for a written contract, which must be signed by you and the customer. The contract must enumerate your responsibilities and the terms of the agreement (e.g., what happens during a delay).
- Maintain proper documentation of invoices: An invoice can also be proof of a completed contract. Since some contracts can be oral, merely showing the invoice is enough proof that there is an agreement between you and the customer.
- Clearly establish your products and services: Every product or service you offer can be a performance obligation in a contract with a customer. You need to clearly establish your products and services to reduce guesswork or arbitrary measurements. How can you give a good transaction price if you don’t have a proper cost basis?
- Recognize revenue as soon as you’re done with your obligation: Suppose a client ordered goods from you. After you deliver the goods to the client, the amount billed is already revenue in your books even if the client hasn’t paid yet. As soon as you’re done with your part—and regardless if payment has been made—you already earned the revenue. Don’t wait for the cash payment to arrive before recording it.
- Seek professional advice when needed: Revenue recognition can be tricky. It’s okay to seek the help of a CPA or professional bookkeeper if you’re unsure how and when revenue should be recognized. We’d rather you consult with an accounting professional than do some guesswork in revenue recognition.
Is ethical revenue recognition relevant to a small business? Yes, all businesses—whether big or small—must ethically recognize and report revenue. Using questionable practices or operating within the “gray area” is unethical.
Unethical Practices With Revenue Recognition
Below are some of the major accounting issues with revenue. We aim to help you understand why revenue recognition is a sensitive topic in accounting.
- Premature revenue recognition: Premature recognition of revenue impacts the quality of information that the financial statement reports. For instance, instead of recognizing revenue on January 5 of the next accounting period, you immediately recognize it on December 30 of the current period to improve the revenue figures of the current period. This type of fraud is called window dressing.
- Earnings management: Another issue with revenue recognition is earnings management. This unethical practice is also known as earnings smoothing. It happens when the business intentionally postpones revenue recognition and spreads it out throughout the year to make it look like the business is consistently earning. Suppose you closed a big-time client that brought $500,000 in revenue to your business. Instead of recognizing it right away, unethical accountants recognize it over time so that months with low or zero revenue will not look that bad.
- Creative accounting: Some businesses are aware that auditors always put a high audit risk in revenue transactions, which means that auditors will conduct more audit procedures for revenue transactions. Hence, unethical accountants or owners don’t manipulate revenue. Instead, they manipulate expenses by recognizing losses and write-offs in the current year with the end goal of making the next accounting period appear more profitable than the previous year.
- Revenue misclassification: One way to manipulate revenue is to misclassify it, especially if a product line is about to be discontinued. Revenue misclassification occurs when you transfer the revenue of an in-demand product to a less popular product just to make it look like the latter is still generating revenue.
Revenue manipulation is unethical and illegal. You can go to prison if you allow improper revenue recognition practices in your business— especially if the end goal is to make the business image better in the eyes of external parties like creditors, lenders, or investors. These issues are why the accounting profession has been very thorough and strict with revenue recognition.
Frequently Asked Questions (FAQs)
The US GAAP follows ASC 606, which is an adopted version of the IFRS 15.
Yes, you need to follow ASC 606 if you’re a publicly traded company. Otherwise, following ASC 606 is not mandatory, and you may follow it at your discretion.
Revenue recognition is the five-step process that guides businesses and accountants in properly recognizing revenue when truly earned. Due to the complexity of business transactions nowadays, revenue recognition has been complicated due to its high risk of being manipulated.
Bottom Line
Knowing what revenue recognition is enables you to properly assess performance, make decisions, and gain investor confidence. Because of the accounting scandals in the past, revenue recognition standards have become stringent, making it more challenging to recognize revenue. As a small business owner, you need to know proper revenue recognition to avoid IRS penalties and surprise audits. And on top of that, it helps you assess business performance based on true and correct information.
