Revenue Recognition

Revenue recognition is an accounting principle that requires monetary value gained from the fulfillment of an obligation in a transaction (revenue) to be recorded and attributed (recognized) at the point when it is earned, rather than when it is received.

Many scenarios exist in business in which the performance of an obligation – the delivery of a product or service -- and the receipt of payment for that obligation do not coincide.

When revenue is earned but not received at the same time, this presents a challenge for accountants who are responsible for maintaining accurate and timely records that reflect on the financial health of the business. Revenue recognition recognizes this challenge and provides a standardized process for addressing it.

The concept of revenue recognition applies equally to situations in which payment arrives before an obligation is performed and when it arrives after.

• If payment arrives first, the business cannot recognize it as revenue until the obligation has been fulfilled. In this way, the business is making an important distinction between cash and revenue. The business may have cash in the bank from the payment, but that cash does not become revenue until it has been earned.

• If payment arrives after an obligation is performed, the business can recognize it as revenue once the product or service has been performed - It does not have to wait for the cash to arrive.

In either case, the event that triggers the revenue recognition is the performance of the obligation. In other words, a business recognizes revenue as soon as, and only when, it is earned. This accomplishes two goals.

1. A business will never consider revenue that has not yet been earned.

2. A business can take credit for revenue that has been earned, even when it has not yet been received. In either instance, accounting records for the business will accurately reflect when the business has fulfilled its obligations to its customers.

In 2014, the Financial Accounting Standards Board (FASB) - which is the designated accounting standard setter for public companies in the U.S. - issued a standard procedure for revenue recognition in conjunction with the International Accounting Standards Board (IASB). The standard is known as the Accounting Standards Codification (ASC) 606.

The standard is based on a core principle:

"An entity will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services."

Based on this core principle, the FASB established a standard process involving five steps that a business should follow in succession:

1. A business must first identify the contract with the customer. An enforceable contract will contain all the necessary details about the transaction, including the rights and obligations of each party, payment terms, and an assumption that the customer will pay for the goods or services rendered.

2. Next, the business must identify the specific performance obligation or promise that is contained within that contract. These are distinct, or stand-alone, goods or services that the business is contracted to provide.

3. Then, the business must determine the price agreed upon for the transaction. The contract should specify how much the business expects to receive in the form of monetary compensation for the good or service it has promised to provide.

4. Once determined, the business must allocate the transaction price to the performance obligation. Sometimes, contracts contain multiple or bundled goods or services. For accurate accounting, the business should segregate multiple performance obligations and appropriately allocate how much compensation the business will receive for each one.

5. Finally, the business will recognize revenue when, or as, it satisfies the performance obligation. This is a timing process that reflects the point in time when the business delivers the product or service that was purchased. In some cases, this can happen over a period, as is the case with subscriptions, memberships or ongoing and recurring deliveries.

Revenue recognition processes can vary depending on the type of transaction. Different scenarios present unique challenges.

In the most basic example, a business produces a product to fulfill a one-time order. Let’s say a toy manufacturer has a contract with a retailer to make 100 bicycles at a cost of $50 for each bike. Once all the bikes have been made and delivered, the manufacturer can recognize the $5000 as revenue for the order, even if the retailer has not made a payment, because the obligation has been fulfilled.

In the same example, if the retailer paid part or all of the order in advance, the manufacturer cannot recognize that payment as revenue until it has made and delivered all the bicycles.

Let’s look at a more complex example: If an online flower delivery service offers a monthly subscription, it cannot recognize any subscription payments made by customers until flowers have been delivered. If a customer pays a monthly fee of $50 at the beginning of each month but flowers are not delivered until the third Thursday of every month, the service cannot recognize the revenue until after the flowers have been delivered.

This process gets even more complicated when a customer pays for the entire subscription all at once (this is common with the purchase of insurance and other products that offer discounts for larger payments). In the same example from above, if the flower delivery customer pays for an entire year of deliveries at a discounted cost of $575, the service will have to calculate the monthly cost and attribute that cost monthly to each delivery – only recognizing the monthly revenue only after each delivery has been made.

Revenue recognition is an important principle that ensures honesty and accuracy in business accounting. Without it, some businesses could exaggerate revenue without any benchmarks, or make planning and budgeting decisions that are not based on actual performance.

The principle also provides an accurate and standardized method for reporting the performance and financial health of a business - which is important for investors, lenders, auditors and internal management staff who make decisions about the business.

Many challenges involved with revenue recognition are related mostly to the process of compiling and maintaining accuracy in the details of the transaction.

For example, if the contract describes a bundle of services or products, the business will need to segregate or separate individual transactions to determine the correct cost that should be assigned to them.

Similarly, if details in a contract change this can complicate the process of defining specific obligations. In these cases, a new or amended contract may be required. Businesses also must make a distinction between when they are acting as a principal, (producing and delivering their own product) and when they are acting as an agent (combining or transferring a product from another provider).

In the case of an agent, the business cannot recognize all of the payment received as revenue, only the portion that reflects its contribution to the product or service delivered.

Sometimes businesses also have difficulty aligning the information that they receive regarding revenue with their internal data concerning contracts and obligations. This can be an issue when transactions involve foreign currency.

Finally, when data that is used for revenue recognition is not stored uniformly in one central database, or in a consistent format, this poses additional challenges for business accountants.