Revenue recognition (accounting)

In accounting, revenue recognition is a generally accepted accounting principle (GAAP), which sets the guidelines for when a business can record revenue, or sales, during a reporting period. According to the general rule, revenue is recognized at the time it is earned and when the amount to be collected is measurable. Both criteria are usually met at the point of sale, when goods are delivered or services are rendered. The proper recognition of revenue is important to understanding a company's financial statements. If revenue is recorded prematurely or belatedly, the statement may not accurately represent the business's financial activities.

The rules for revenue recognition have historically differed among industries and countries. In 2002, the Financial Accounting Standards Board (FASB)—which determines GAAP in the United States—and the International Accounting Standards Board (IASB)—which sets the International Financial Reporting Standards (IFRS) for the European Union and other countries—agreed to collaborate to improve and standardize accounting standards in what became known as the Norwalk Agreement. In 2014, the boards met to issue new standards that provided uniform guidance on how companies recognize revenue. These changes provided a framework for addressing revenue issues, eliminated inconsistent guidance in existing revenue requirements, and standardized revenue recognition practices across entities, industries, jurisdictions, and capital markets to allow better comparability.

Background

Revenue, the sale of goods and services to customers, is the top line of a company's income statement and a vital tool in evaluating a business's prospects. Revenue is a key measure of a business's growth and performance. Sales indicate the success of the company in the marketplace. The recognition of revenue differs under the two key methods that businesses use to track revenue: accrual accounting and cash accounting. The two techniques differ with respect to the timing of when revenue is recorded.

In accrual accounting, revenue is recognized when the sale of goods and services occurs—the point of sale—whether cash is received or not. If payment is not given at that time, the amount of cash that will be collected is a determinable sum. When revenue is recorded before the payment is received, it is called accrual revenue. When revenue is recorded after the payment is received, it is called deferred revenue.

In cash accounting, revenue is recognized when cash is received, regardless of when the goods or services are sold.

Several exceptions to the general rule that revenue is recognized at the point of sale exist, including the collectability of receivables, percentage of completion method, and proportional revenue recognition.

The collectability of receivables refers to the company's ability to receive payment upon delivery of a good or service. If the company is feeling uncertain that it will collect payment from the buyer at the point of sale, then the company should delay recognition of revenue until it receives the cash. This technique is used in real estate transactions.

Under the percentage of completion method, revenue can be recognized each year during a multiyear contract project. This technique is frequently used with long-range construction projects, such as bridges, buildings, or aircraft, which can take many years to finish. This method recognizes a portion of the revenue based on the percentage of the project completed.

Proportional revenue recognition is similar to the percentage of completion method, but this technique is applied to service contracts. For example, a gym offers a one-year membership for an up-front payment of $500. It would be misleading for the gym to recognize the revenue at the point of sale because the process of rendering the service has just begun. Under GAAP, the gym is permitted to record the revenue each month during the length of the contract.

Overview

Most companies report their methods of revenue recognition in the notes of their financial statements. The appropriate recording of revenue presents investors with an accurate reading of a business's state of affairs. If revenue is recorded too early or too late, the financial report could present an inaccurate snapshot of the company.

Historically, the US GAAP and the IFRS have used different requirements for revenue recognition. The rules vary among countries and industries. This variance in rules caused similar transactions to be recorded differently. To streamline the guidelines, the FASB and the IASB announced in 2014 a converged set of standards for the recognition of revenue in GAAP and IFRS called the Accounting Standards Codification (ASC) 606. The guidelines affected all organizations that had contracts with customers. The goals of these standards were to enhance the consistency and transparency of financial reporting and improve the ability to compare revenue reported across companies and industries.

The ASC 606 guidelines are based on the core principle that companies should record revenue to show the sale of goods or services in amounts that accurately reflect the payment the company expects to receive from customers. The standards represented a switch in accounting guidelines based on rules to an emphasis on principles. The guidelines replaced the industry-specific rules. Companies must follow a five-step process to recognize revenue:

• Identify the contract with a customer. Under the current guidance, revenue recognition is forbidden until a contract is signed. The new guidelines allow for a contract to be written, verbal, or even implied between a company and customer.
• Identify the performance obligations in the contract. The new guidelines introduce the concept of a performance obligation, which is the promise that the company will deliver each good or service provided in the transaction.
• Determine the transaction price. The organization must determine the price based on the estimate of what it expects to receive from the customer. The estimate must be made upfront when the contract is drawn.
• Allocate the transaction price to the performance obligations in the contract. If at least two goods or services are being sold, the price must be distributed among all goods or services involved.
• Recognize revenue when or as each performance obligation is satisfied. The company can record the revenue allocated to each good or service upon delivery. Depending on when each obligation is met, some revenue may be reported immediately while the remaining revenue may be deferred.

The FASB and the IASB decided to delay the original implementation date of the new revenue recognition standards by one year to give businesses more time to make the changes. Because of the delay, public entities began applying the guidance on January 1, 2018 and private entities on January 1, 2019.

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