What is Revenue Recognition: Principle, Model & Examples

Introduction

Revenue is a key metric for an organization that enables us to gauge its performance and financial health. Recording revenue correctly is the key to ensuring accuracy in financial reporting. This is where revenue recognition steps in, specifying how and when revenue should be recognized.

As one of the principles associated with Generally Accepted Accounting Principles (GAAP) reporting, adhering to revenue recognition principles enables organizations to become GAAP-compliant, adding credibility to their financial reporting.

In this article, we will delve into understanding the revenue recognition principle, the five-step model for revenue recognition, its types, and why revenue recognition is important for ensuring financial statement accuracy.

What Is Revenue Recognition?

Revenue recognition is a core element of accrual accounting that states that revenue should be recognized in the period in which it is earned, irrespective of whether a cash transaction has occurred. It is a GAAP principle that determines when and how revenue is recognized, or recorded, in a firm’s financial statements.

In essence, revenue recognition states that an organization can record and recognize revenue in its profit and loss statement only when it fulfills its obligations to its customers,i.e., when it delivers goods or services to the customers in that accounting period and not when it receives cash from the customer. Further, to record revenue, there has to be a certain degree of assurance to the organization that they will receive the payment from the customer. Understanding which transactions can be recognized as revenue is often complex, which makes it essential for organizations to understand what the revenue recognition principle entails. 

What is Accounting Standards Codification (ASC) 606?

Accounting Standards Codification (ASC) 606 provides a comprehensive framework to recognize revenue for organizations of all sizes across industries. The Financial Accounting Standards Board (FASB) issued ASC 606 on May 28, 2014, in collaboration with the International Accounting Standards Board (IASB). 

Before 2014, the guidance for revenue recognition and contracts was industry-specific, which made it fragmented and difficult to implement. Further, owing to this disparity, it was difficult to compare the performance of companies across industries. ASC 606 ensured that the guidelines are industry-agnostic which ensures consistency in revenue recognition across industries and business models. ASC 606 has standardized revenue recognition and ensured that all organizations adhere to the five-step shared guidelines under ASC 606. With ASC 606 in place, one can conduct financial analysis and compare the financial performance of organizations accurately.

Five-step Revenue Recognition Model

ASC 606 is a shared framework issued by FASB for revenue recognition applicable to all organizations across industries. This framework ensured that the process of revenue recognition was consistent for all organizations across industries. The five-steps of revenue recognition are as follows:

1. Identify the contract with the customer

This step involves all parties involved agreeing to the terms of the contract, where contracts can be in written or non-written format, such as verbal commitments. The contract lays down the terms and conditions related to payment terms, details around the delivery of goods and services, and the rights and obligations of the parties involved. It also highlights the commitment of the parties to fulfill their obligations. The contract also mentions collectability, which is an assurance to the seller that they will receive the payment. 

2. Identify the performance obligations in the contract

Performance obligation is a promise to transfer goods and services to the customer. Organizations need to identify all the distinct performance obligations that they need to fulfill and are mentioned in the contract. For a good or service to be identified as performance obligation, it needs to fulfill two criteria:

• The goods and services should be able to provide value to the customer on their own or in combination with other resources that the customer has access to. 
• The goods and services should be distinct and not dependent on other performance obligations mentioned in the contract. An organization should be able to transfer goods and services independently. 

Goods and services that are not distinct can be combined with other goods and services until they are distinct, post which we can recognize them as a performance obligation in the contract. For example, when an organization sells a software product, the software mentioned in the contract is a performance obligation.

3. Determine the transaction price

The transaction price denotes the consideration an entity expects to be entitled to for the transfer of goods or services. To express it in simple terms, it denotes the cash that the organization expects from the customer for delivering the goods or services. The transaction price is associated with a performance obligation. However, the determination of transaction price is often complicated, as organizations need to take into consideration various factors that impact transaction price. These include:

• Variable consideration: Variable consideration is when the consideration amount can change due to factors such as timing and performance. Variable considerations include discounts, credits, rebates and refunds. 
• Non-cash consideration: This is when organizations receive non-cash consideration, such as goods, services, or stock, for the delivery of promised goods or services. Generally, non-cash considerations are included at fair value in the contract. 
• Consideration payable or paid to customers: This includes considerations such as rebates, refunds, and coupons that are payable to the customer. These considerations generally reduce the transaction price.
• Presence of significant financing: Significant financing is taken into consideration when there is a gap of more than a year between payment and the delivery of goods or services. Here, we take the time value of money into consideration. 

4. Allocate the transaction price to the performance obligations

Once the transaction price is determined, organizations or sellers need to allocate the transaction price to each performance obligation mentioned in the contract based on the relative standalone selling price. When there are multiple performance obligations,organizations need to identify the variable considerations and ensure that they are correctly allocated to the related performance obligation. If there is any change in the transaction price, organizations can either modify the existing contract or create a new contract. If they decide to modify the existing contract, the changes in transaction price must be allocated to the performance obligation based on the same method that was used when the contract was created.

5. Recognize revenue when (or as) the performance obligation is satisfied

The final step in the revenue recognition model is to recognize revenue as and when the performance obligations are satisfied. We consider a performance obligation to be satisfied as and when the control of goods or services is transferred to the customer. Two key aspects to consider here are whether the obligations are being satisfied at a point in time or over time. 

• Performance obligations satisfied at a point in time: Here, the revenue is recognized when the performance obligation is fulfilled. The determination of when control is transferred to the customer is the key to deciding when revenue should be recognized. 

• Performance obligations satisfied over time: Here, organizations need to determine how they will gauge the progress of the performance obligations and their final completion. For a performance obligation to be identified as being satisfied over time, it needs to fulfill these criteria: i) the customer simultaneously receives and consumes the obligation as the seller continues to work ii) as the seller works, the performance obligations create or enhance the assets that the customer controls iii) the performance obligation does create an asset for the seller i.e., the seller, has no alternative use for the asset other than providing it to the customer it is contractually obligated to. Further, the seller cannot sell the asset to any other customer.The seller, in turn, has the right to receive payment from the customer for the work that they have delivered so far. 

• For performance obligations fulfilled over time, to determine if the obligation is satisfied, organizations can use the input or output method. In the input method,to gauge performance, one considers the efforts spent or material consumed so far. For the output method, one measures performance based on the goods or services delivered so far and the value provided to the customer. 

Principles of Revenue Recognition

The revenue recognition principle under ASC 606 states that revenue can only be recognized when the promised goods or services are delivered to the customer. A core part of accrual accounting, the revenue recognition principle is integral to the GAAP principle. Apart from GAAP, the revenue recognition principle is also integral to International Financial Reporting Standards (IFRS). 

To recognize revenue under IFRS, conditions under three categories i) performance ii) collectability iii) measurability must be fulfilled. Performance denotes that the organization has fulfilled their obligations to their customer; collectability denotes that the organization has assurance to be paid for the delivery of goods or services; and measurability ensures that the revenue recognition principle matches the matching principle. In other words, the revenue is recognized in the same accounting period in which the expense is recorded. 

To adhere to the IFRS revenue recognition principle, there are a set of five conditions that must be met. 

GAAP Revenue Recognition Principle

Previous revenue recognition principle was industry-specific, which made it complex and difficult to implement. However, in 2014, FASB issued ASC 606, a standardized five-step framework, for revenue recognition under GAAP which ensured consistency in how organizations recognized revenue.

This principle ensures that revenue recognition is in line with accrual accounting, where revenue is recognized in the period in which it is earned and is not dependent on actual cash transactions. All public companies in the U.S. that adhere to GAAP for their financial statement reporting need to follow the revenue recognition principle under GAAP.

Types of Revenue Recognition with Examples

While the ASC 606 five-step framework for revenue recognition describes what aspects organizations need to consider to record revenue, there are certain factors specific to how organizations fulfill their performance obligations that further fine tune the revenue recognition process. The different types of revenue recognition are as follows:

1. Sale-basis method

This method generally involves physical goods, and revenue recognition takes place the moment the goods are sold. This is because once the goods are sold, their risks and ownership transfers to the buyer, and the seller no longer has control over them. Here, we do take into consideration variables such as discounts, refunds and rebates, if any. The invoice, or sales agreement here, is the contract. 

For example, ABS sells electronic goods. A customer buys two laptops amounting to $500 each. Here, revenue recognition for the ABS coincides with the sale of the laptop. So assuming that ABS has assets worth 10 laptops, their ledger will be updated as

2. Completed-contract method

In this method, we recognize revenue only when all the obligations laid down in the contract are completed. Here, both revenue and expense are determined after the fulfillment of the contract, as gauging the revenue as the work progresses is often difficult to estimate. This is generally conducive for short-term contracts and cannot be utilized if companies are providing extended warranties and return periods. 

For example, let us take an event management company that has entered into a contract with an organization to organize a week-long seminar for $50,000. The event company uses the completion-contract method for revenue recognition so they will receive the payment only after the contract is fulfilled. At the beginning the ledger of the company would reflect as 

Ledger entry 

Once the contract is fulfilled, the event company receives $50,000. So related ledger entries will be 

3. Installment sales method

This method is used when customers do not pay the entire price up front but pay it over a period of time as installments. This is mainly applicable in the case of purchase of high ticket goods such as real estate, machinery, equipment and appliances. Here, revenue is recognized as a percentage of the total revenue as and when the payment is received. 

For example, let us assume that a company sells equipment worth $10,000 to a customer with an installment period of 5 months. So each month, the customer will pay an installment amount of $2000. At the beginning as the organization has not received any payment they will have accounts receivables of $10,000. As the installment is received each month, the accounts receivables will be debited with the installment amount of $2000 and the revenue will be recognized. 

Ledger entry after first installment received

4. Subscription method

In this method, the revenue is recognized over time as the service is utilized by the customer. Here, payments can vary from annual, quarterly, to monthly. Here, the customer derives value from the goods or services over a period of time, and revenue is recognized linearly across the subscription period. 

For example, let’s take a company that delivers curated books to customers monthly as a book box. The subscription price for this book box is $10 per month. Now the customers pay the company at the beginning of the month, however, the book box is delivered at the end of each month. The payment received at the beginning of the month will be deferred revenue. The organization can recognize revenue only at month-end when they have delivered the goods or service. 

Ledger entry at the end of the month after delivery of goods

5. Percentage of completion method

Generally undertaken for long-term projects, in this method, the revenue is recognized in proportion to the work completed as the project progresses. Revenue is ascertained based on the milestones achieved. This method is generally utilized in the construction industry. 

For example, a construction company will be building an auditorium over 3 years. At the end of the first year, the construction is completed by 25%. The total expense mentioned in the contract is $100,000. So at the end of the first year we need to consider 25% of $100,000, which is $25,000. So ledger entry at the end of first year will be 

How HighRadius Can Help?

To ensure accurate revenue recognition, organizations need to track transactions in real-time and ensure that all records are updated. Manually doing so is complicated, tiresome and prone to errors. To offset these challenges, organizations should leverage accounting software that transforms and automates accounting processes. HighRadius Record to Report (R2R) solutions offer end-to-end capabilities to streamline and automate accounting processes and workflows. 

With AI-enabled transaction matching, Account Reconciliation enables organizations to automate data extraction from ERP and bank sources, ensuring automated transaction matching.From data fetching to journal entry and analysis, HighRadius empowers organizations to achieve a groundbreaking 50% reduction in manual tasks through its no-code platform, LiveCube. Accountants can effortlessly retrieve raw data, perform calculations, and seamlessly upload results into various enterprise systems, streamlining the entire record-keeping workflow.

HighRadius R2R solution not only provides organizations with a powerful, AI-driven platform that enhances efficiency and accuracy but also fundamentally changes the way organizations approach and execute their accounting processes.

FAQs

1. What is income recognition?

Income revenue commonly referred as revenue recognition, states that revenue should be recognized only when it is earned irrespective of whether cash transaction has occurred. A core feature of accrual accounting, it dictates when and how income should be recorded. It is also integral to GAAP accounting. 

2. According to GAAP when is income reported?

GAAP mandates that income or revenue should adhere to the revenue recognition principle for it to be recognized. This means that revenue should be recognized in the accounting period in which it is earned and realized irrespective of whether cash has been received. Revenue recognition is a core GAAP principle.

3. When is revenue recognized in accrual accounting?

Revenue is recognized in accrual accounting, only when the revenue is earned and realized not when payment is received. Under accrual accounting, revenue recognition should align with matching principle i.e., the revenue should be recognized in the same period in which related expenses are recorded. 

4. Why is revenue recognition important?

Revenue recognition is important as it standardizes the process of revenue recognition for organizations across industries ensuring accuracy in financial reporting. It ensures consistency in financial reporting which allows for analysis and comparison of organizations to gauge its relative performance. 

5. Do all businesses need to follow revenue recognition principles?

All public companies in the U.S who adhere to GAAP reporting must follow revenue recognition principle as revenue recognition is a core part of GAAP accounting. Further, all businesses that comply with IFRS must also follow the revenue recognition principle.

6. What are the five-steps of revenue recognition?

The five-steps of revenue recognition is the framework provided by ASC 606 for revenue recognition for all organizations. These are identifying the contract, identifying performance obligations, determining the transaction price, allocating price to obligations and revenue recognition.