What is Revenue Recognition?
Revenue recognition is the accounting principle that governs how and when companies can record revenue. It’s a set of rules that standardize the way companies around the world measure revenue. It lays out the clear process and conditions that companies must follow in order to recognize any revenue.
Revenue is one of the most important metrics on the financial statements. It’s the first line on the Income Statement and influences all the lines that follow. How much revenue a company generates influences profit, cash flow and even valuation. Therefore, revenue is an essential metric in analyzing a company’s financial health and future prospects.
At a conceptual high level, companies recognize revenue when the following conditions are met.
- The company has transferred the goods / services to the customer.
- The collection of payment for the goods / services is reasonably certain.
In accounting language, we say that the collection of payment is probable and the company has satisfied the performance obligations. If you’re short on time, these two conditions are the key takeaways. The rest of this article will go over the revenue recognition standards in greater details.
For many businesses, revenue transactions are simple and straightforward. At a supermarket, customers take the product home and pay at the checkout counter. At a restaurant, customers consume the meal and pay on site. These companies provided the goods to the customer and the collection of payment was reasonably certain. However, there are also many other businesses with more complicated revenue transactions. These businesses rely on revenue recognition standards to guide them on when and how to record revenue.
Accounting Standards for Revenue Recognition
Sizable companies can’t just record revenue however they want. They must follow the revenue recognition rules set in the accounting standards. In the United States, companies follow the US GAAP maintained by the Financial Accounting Standards Board (FASB). For most of the rest of the world, companies follow the IFRS maintained by the International Accounting Standards Board (IASB).
Revenue Recognition Before May 2014
Prior to May 2014, revenue recognition policies were very problematic in both US GAAP and IFRS. The US GAAP was way too detailed. It had complex and disparate revenue recognition requirements for specific transactions and industries, such as software, real estate, and construction. As a result, different industries followed different accounting rules for economically similar transactions. By contrast, the IFRS was too lacking in details. It provided limited guidance and companies found the guidance difficult to apply. As a result, the FASB and the IASB worked together on a joint initiative to create a new set of revenue recognition accounting standards.
Revenue Recognition After May 2014
In May 2014, the FASB issued Topic 606, Revenue from Contracts with Customers. In the same month, the IASB issued IFRS 15, Revenue from Contracts with Customers. Along with other consequential amendments, these documents stipulate the new revenue recognition standards that companies around the world follow. The new standards also largely converged the US GAAP and IFRS revenue recognition requirements and eliminated most previous differences.
As previously explained in the first section, many businesses have very simple and straightforward revenue transactions. However, many other businesses have complicated revenue transactions. Examples include real estate construction arrangements, intellectual property licenses, and services with milestone payments. These might make it difficult to determine what the company has committed to deliver, the revenue amount and when revenue should be recorded.
Due to the convoluted nature of these transactions, companies and customers would enter into contracts. That’s why both the US GAAP and IFRS documentations reference “contracts with customers”. The new standards use these contracts with the customers as the basis for recording revenue.
The 5-Step Revenue Recognition Process
Under the new standards, both the US GAAP and the IFRS adopted a 5-step process to recognize revenue.
- Identify the contract with a customer.
- Identify the performance obligations (promise) in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the reporting organization satisfies a performance obligation.
Companies must believe that the collection of payment is reasonably certain (“probable”) before they commence the 5-step process.
Step 1: Identify the Contract
The first step in applying the new revenue recognition standard is to identify the contract with a customer. This is very straightforward. The key here is that the counterparty to the contract must be a customer. Contracts that are not with customers are outside the scope of the revenue recognition standard.
For example, Company A signs contract with Company B to jointly build a mall whereby Company B will control the mall and pay a fixed amount of money to Company A. Should Company A recognize the money it receives from Company B as revenue? It depends. If Company A and Company B are acting as partners, then Company A can’t recognize the payments as revenue. Company A might have to categorize the payments as dividend payments or investment income. If Company B is a customer receiving service from Company A, then Company A may recognize the payment as revenue.
Step 2: Identify the Performance Obligations
The second step in applying the new revenue recognition standard is to identify the performance obligations in the contract. Under the new standards, performance obligations are the unit of account. Therefore, performance obligations serve as the basis for how and when to recognize revenue. Management needs to evaluate whether to categorize multiple promised goods / services separately or as a single obligation.
In many businesses, the performance obligation is very straightforward. For example, in a restaurant, the performance obligation is likely the service of meals to the customer. The following are other examples of performance obligations.
- Netflix granting access to its shows and movies for a monthly subscription.
- Apple delivering iPhone that customer ordered on its website.
- Citibank safeguarding the money that customers deposited.
Step 3: Determine the Transaction Price
The third step in applying the new revenue recognition standard is to determine the transaction price. The transaction price is the amount a company expects to be entitled in exchange for goods or services transferred. Management should take into account both fixed and variable considerations of the transaction price.
A common question people have is whether companies record sales taxes in revenue. The new standards state that amounts collected on behalf of third parties should be excluded. Companies collect sales taxes on behalf of the government. Therefore, companies may not include sales taxes in revenue.
Step 4: Allocate the Transaction Price
The fourth step in applying the new revenue recognition standard is to allocate the transaction price. The objective is to allocate the transaction price to each performance obligation. The amount allocated should depict the amount the company expects to be entitled for fulfilling that obligation.
Here’s a key concept. The transaction price should be allocated to each performance obligation based on the relative standalone selling prices of the goods or services being provided to the customer. For example, let’s take a look at Microsoft. Suppose Microsoft sells its Surface laptop for $1,000 and Office 365 for $500. If a customer were to purchase the laptop on its own, then the standalone selling price is $1,000. And if the customer were to purchase bot the laptop and Office 365 separately, the total price is $1,500. But what if Microsoft sells the Surface laptop with Office 365 to a customer as a bundle for $1,300? How should Microsoft recognize revenue from the sale of laptop versus from the sale of Office 365?
Using the standalone selling prices, Microsoft should calculate the laptop revenue as ($1,000 / $1,500) x $1,300. Similarly, Microsoft should calculate Office 365 revenue as ($500 / $1,500) x $1,300. Therefore, Microsoft should allocate $866.67 of revenue to the laptop and $433.33 of revenue to Office 365.
Step 5: Recognize Revenue
The fifth and final step in applying the new revenue recognition standard is to recognize the revenue. The accounting standards require companies to recognize revenue when performance obligations are satisfied. A performance obligation is satisfied when the “control” of the promised good or service is transferred to the customer.
Remember that companies must determine that the collection of payment is probable before they even commence the 5-step process. Therefore, the two conditions to recognize revenue are what we stated in the beginning.
- The collection of payment for the goods / services is reasonably certain.
- The company has transferred the goods / services to the customer.
Conclusion
Revenue recognition is a set of accounting rules that govern how and when companies may record revenue. It used to be very complicated with different rules for different industries and major discrepancies between US GAAP and IFRS. After 2014, the FASB and the IASB introduced a 5-step process that standardizes how companies recognize revenue. Companies recognize revenue when the collection of payment is probable and performance obligation is satisfied.