REVENUE RECOGNITION:
What Is Revenue Recognition?
A business determines when revenue is recorded using revenue recognition. This accounting method is used for such instances as when goods or services are delivered to a customer rather than when payment is received.
Following revenue recognition guidelines prevents companies from overstating or misrepresenting their financial health, helping avoid financial manipulation. Revenue recognition rules assist all stakeholders in comparing companies accurately and provide them with transparency and confidence.
Key Takeaways
- Companies can follow two main accounting methods: cash accounting and accrual accounting.
- Accrual accounting must be used by larger and publicly traded companies.
- The revenue recognition principle under accrual accounting states that companies must record revenue when it's earned not when cash has been received.
- Cash accounting is simpler and can be used by smaller companies.
- The five-step process under GAAP and IFRS accounting standards helps companies accurately report revenue.
5 Steps of Revenue Recognition
Public companies must abide by either GAAP or IFRS standards, depending on their location. Regulators created the five-step model under ASC 606 (GAAP) and IFRS 15 to standardize how companies report revenue.
These are the five steps:
1. Establish a contract with the customer: A contract between a business and a customer establishes each party's responsibilities. The contract can be written, verbal, or implied.
2. Identify performance obligations: Performance obligations stipulate the "promises" that must be fulfilled, which are the delivery of goods and services. Each contract can have multiple performance obligations.
3. Set the transaction price: The transaction price is the amount the company expects to be paid for fulfilling its performance obligations. It's essentially what it will be paid for delivering goods or services.
4. Allocate the transaction price: Contracts can have multiple performance obligations so the transaction price must be divided among each performance obligation "on the basis of the relative stand-alone selling prices."
5. Recognize revenue when an obligation is fulfilled: Revenue must be recognized when a business transfers its product or service, fulfilling its performance obligation. Businesses can fulfill obligations at a single point in time or over a set period depending on the contract.
ASC 606 Revenue Recognition Criteria
When a company enters into a contract with a customer, certain criteria must be met for revenue recognition under ASC 606:
- It is clearly evident that a financial arrangement exists
- The delivery of the product or service is completed
- The customer’s price is measurable and fixed
- The seller can reasonably expect to collect the funds
Example of Revenue Recognition
Company ABC, a software company, sells a four-year cloud storage subscription for $48,000 which is paid upfront. There's also a $5,000 one-time setup fee. ABC would recognize revenue in the following way:
- It will record $1,000 a month for four years ($1,000 x 48 months = $48,000) rather than record the $48,000 right away.
- The $5,000 one-time setup fee is recorded immediately because the setup service is delivered to the customer immediately.
Common Revenue Recognition Methods:
Sales-Basis Method:
Recognizes revenue when the sale occurs and title transfers to the buyer. Common for goods sales, this method aligns revenue with ownership transfer.
Completed-Contract Method:
Records revenue and expenses only when a long-term contract is completed. Used for projects where it’s difficult to estimate progress, providing a conservative approach.
Cost-Recoverability Method:
Delays profit recognition until all project costs are recouped. Often used when there’s uncertainty about the recoverability of costs, ensuring profit isn’t recognized prematurely.
Percentage-of-Completion Method:
Recognizes revenue and expenses proportionally based on the percentage of work completed in long-term projects, offering a more accurate reflection of financial performance over time.
Installment Method:
Recognizes revenue as payments are received from the customer, with profit recorded proportionally. Ideal for transactions with uncertain collections.
Brokerage Agreement Method:
Follows IRS and SEC rules for brokers, recognizing revenue from brokerage services in compliance with regulatory requirements.
Accrual Method:
Recognizes revenue when earned (not when cash is received), matching it with related expenses. It records prepayments as assets and later reclassifies them as expenses when goods or services are delivered.
Appreciation Method:
Recognizes revenue based on the increase in property value over time, typically used in real estate, reflecting the economic benefit derived from the property’s appreciation.
Proportional Performance Method:
A variation of the percentage-of-completion method, where revenue is recognized based on the proportion of performance completed, but profit is recognized instead of costs incurred.
Deposit Method:
Revenue is initially recorded as a liability when a deposit is received. It is recognized as revenue only after the cancellation period ends or customer obligations are fulfilled.
Bill & Hold Method:
Revenue is recognized when goods are billed to the customer, even if not physically delivered, provided certain conditions (e.g., buyer request, goods identified separately) are met. Used to prevent fraudulent inflation of assets.
APPLYING THE GUIDANCE TO LONG-TERM CONTRACTS
ASC 606 supersedes the guidance for long-term contracts provided by ASC 605. Under the old guidance, companies often had the option of accounting for long-term contracts through either the completed contract method or the percentage-of-completion method (the recommended method when reliable estimates were possible). The main conceptual changes that the new guidance in ASC 606 prescribes for long-term contracts are (1) the requirements to divide a contract into separate performance obligations, assigning a transaction price to each, and (2) determining when the customer has control of the contracted good or service. These key changes can translate to dramatic differences in the timing of revenue, expense, and profit recognition for long-term contracts.
Regarding performance obligation transaction prices, the FASB states that an entity should allocate the transaction price to each performance obligation based upon its observed or estimated stand-alone selling price at contract inception. On the issue of control, an entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when (or as) the customer obtains control of that good or service. ASC 606 states that an entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time if at least one of the following criteria is met:
1. The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
2. The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
3. The entity’s performance doesn’t create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
For performance obligations that an entity satisfies (and recognizes revenue for) over time, the contractor should consistently apply a method of measuring the progress toward complete satisfaction of that performance obligation using either an output method (e.g., units of delivery) or an input method (e.g., costs incurred). If a contractor doesn’t satisfy a performance obligation over time, the performance obligation is considered to be satisfied (and revenue recognized) at the point in time when control is transferred to the customer.
COMPARING OLD GUIDANCE TO NEW
In the following hypothetical example, we demonstrate the accounting techniques for a long-term contract under both the old (ASC 605) and new (ASC 606) revenue guidance. In doing so, we highlight key differences between the old and new standards as well as the inherent managerial discretion that now exists in revenue and expense recognition timing based on the structure of a specific long-term contract.
For this example, assume a contractor has signed a long-term contract with a customer. The estimated duration of the contract is three years. The estimated total contractor cost from the contract is $600,000. And the total contractor revenue from the contract is $1.2 million. As revenue is typically recognized when work is both completed and billed to the customer, we assume that all appropriate customer billing is made without delay. The following scenarios illustrate the procedures for revenue recognition under ASC 605 and ASC 606.
Scenario 1: Use of completed contract method (ASC 605). Under ASC 605, contractors could choose to use the completed contract method in certain instances. In doing so, the contractor wouldn’t need to establish who was the controlling party of the good or service during the contract period. Neither would the contractor need to separate the contract into individual performance obligations (which is the case under ASC 606). It would simply defer the recognition of all revenue and expense until the entire contract was completed. Thus, the total contract revenue of $1.2 million and total expense of $600,000 would both be recognized upon contract completion in Year 3 (see Table 1).
Scenario 2: Use of percentage-of-completion method (ASC 605). Under Topic 605, contractors commonly used the percentage-of-completion method. In doing so, the contractor wouldn’t need to establish who was the controlling party of the good or service during the contract period. Neither would it need to separate the contract into individual performance obligations. It would recognize expense periodically as contract work was completed and could measure progress using either an input method (e.g., costs incurred) or output method (e.g., units of delivery). In our example, for simplicity, assume that progress occurs evenly over the three years of the contract. Thus, as shown in Table 2, revenue per year equals $400,000 ($1.2 million contract value divided by three years), and the expense per year equals $200,000 ($600,000 contract cost divided by three years). Scenario 3: Identification of multiple performance obligations, recognizing revenue over time due to a customer having control of contract goods and services for the duration of the contract (ASC 606). Under ASC 606, the contractor must determine which party has control over the contract goods and services during the contract period. In addition, it must separate the contract into individual performance obligations and assign a transaction price to each based on observed or estimated stand-alone sales price. For this scenario, assume that the customer has control for the duration of the contract. Thus, based on the FASB criteria, the contractor would recognize revenue over time (as opposed to a point in time when control is eventually transferred). In assigning transaction prices (and costs) to separate performance obligations, unequal profit margins on the separate obligations could mean that more or less revenue might be recognized relative to cost depending on which obligation was being satisfied. In this case, the timing of revenue recognition on the overall contract wouldn’t simply mirror that of the percentage-of-completion method under the old guidance. For example, using the percentage-of-completion method, 40% of the total contract cost incurred would normally mean 40% of the revenue recognized. Under Topic 606, however, when high-margin performance obligations are completed first, 40% of total contract cost being incurred may correspond to much more than 40% of total contract revenue being recognized. (Note the inherent managerial discretion that exists in structuring long-term contracts at the outset when discussing the subsequent revenue and expense recognition from these contracts.) For this scenario, assume that the overall contract consists of two performance obligations:
- Obligation 1 (high-profit-margin) has a transaction price of $500,000 and $100,000 in cost.
- Obligation 2 (low-profit-margin) has a transaction price of $700,000 and $500,000 in cost.
Since the obligations have unequal profit margins, the amount of revenue recognized will be different based on which obligation is getting satisfied as costs are incurred.
For Scenario 3, we present two situations (see Table 3): Scenario 3A: High-profit-margin obligation satisfied first. Assume that Obligation 1 (the high-profit-margin obligation) is satisfied by the end of Year 1 and Obligation 2 (low-profit-margin obligation) is satisfied over three years as follows: 20% in Year 1, 40% in Year 2, and 40% in Year 3.
The recorded expense per year in this scenario is the same as Scenario 2’s percentage-of-completion method under ASC 605. In this scenario, however, both revenue and profit recognition are accelerated relative to the percentage-of-completion method because (1) the high-profit-margin obligation was satisfied more quickly than was the low-profit-margin obligation, and (2) revenue was recognized over time, as opposed to a point in time, due to the customer having control.
Scenario 3B: Low-profit-margin obligation satisfied first. In this situation, assume that Obligation 2 (low-profit-margin obligation) is satisfied by the end of Year 1 and Obligation 1 (high-profit-margin obligation) is satisfied over three years as follows: 20% in Year 1, 40% in Year 2, and 40% in Year 3.
This situation shows delayed profit recognition compared to Scenario 3A even though the low-profit-margin work is being performed more quickly than the high-profit-margin work is. The result is greatly accelerated expense recognition overshadowing mild accelerated revenue recognition and, consequently, delayed profit recognition.
Scenario 4: Identification of multiple performance obligations and recognizing revenue at a point in time due to contractor having control of goods and services for the duration of each performance obligation (ASC 606). For this scenario, assume that the overall contract consists of the same two performance obligations (with the same transaction prices and costs) in Scenario 3. The difference in this scenario is that we assume that the contractor has control of the goods and services for each performance obligation until that obligation is satisfied. At that point, control would transfer to the customer, and the contractor would recognize the revenue for the satisfied obligation. We present two situations for this scenario as well (see Table 4):
Scenario 4A: High-profit-margin obligation satisfied first. Assume that Obligation 1 (high-profit-margin obligation) is satisfied by the end of Year 1 and Obligation 2 (low-profit-margin obligation) is satisfied over three years as follows: 20% in Year 1, 40% in Year 2, and 40% in Year 3.
This situation shows accelerated revenue and profit recognition compared to Scenario 2’s percentage-of-completion method under ASC 605. This is due to the high-profit-margin obligation being completed before the low-profit-margin obligation. Yet this situation shows delayed revenue and profit recognition compared to Scenario 3A. Because the contractor has control in this scenario, revenue recognition occurs only upon completion of the performance obligation instead of over time as in Scenario 3A.
Scenario 4B: Low-profit-margin obligation satisfied first. Assume that Obligation 2 (low-profit-margin obligation) is satisfied by the end of Year 1 and Obligation 1 is satisfied over three years as follows: 20% in Year 1, 40% in Year 2, and 40% in Year 3.
Scenario 4B shows delayed profit recognition compared to Scenario 4A. The contractor has control in both situations, but 4B shows the low-profit-margin work being performed more quickly than the high-profit-margin work. The result is a greatly accelerated expense recognition overshadowing mild accelerated revenue recognition and, consequently, delayed profit recognition.
Figure 1 presents the potentially dramatic differences in reported income across time periods described in the different scenarios and situations. All of this indicates that under ASC 606, all else being equal, higher-margin work being determined to have been performed first will result in accelerated income recognition relative to the traditional percentage-of-completion method, while lower-margin work being determined to have been performed first will result in delayed income recognition.
BENEFITS AND RISKS OF ASC 606
Under the new revenue recognition guidance, managers now have more discretion with respect to revenue and cost recognition across time periods than when using the traditional percentage-of-completion or completed contract methods. This stems from their need to now determine the separate performance obligations within the overall contract, the revenue and costs allocated to each, and any discretion they may have in the sequence that the obligations are determined to be satisfied. As is often the case with accrual accounting, this additional managerial discretion could enable managers to produce more accurate and nuanced financial reports relative to those under ASC 605; at the same time, it could theoretically be exploited by managers to more easily engage in earnings management or manipulation. Opportunistic managers could achieve such objectives through the initial structure of the contract and creation of specific performance obligations as well as through the obligation revenue and cost estimates and the sequence that they’re determined to be satisfied.
Due to the additional managerial discretion and nuance inherent in ASC 606, along with the central role that revenue recognition plays in reported financial performance, we believe both financial statement preparers and users benefit from a clear understanding of these significant rule changes. For managers, additional contract documentation and analysis may be warranted, especially as it relates to potential complexities surrounding, for example, the process of determining distinct performance obligations and their transaction prices.
The question of when customer acceptance or control has occurred can also require careful judgment. For their role in assessing managerial estimates, ASC 606 may justify additional documentation and analysis for auditors—who should be mindful of the potential threat to their independence in the event they become too involved in the client’s implementation of ASC 606. We believe that the relatively recent implementation of ASC 606, coupled with the unusual economic conditions of the last couple of years, mean these new revenue recognition standards are worthy of continued focus. It may still be too early to fully identify the significant changes being brought about by their implementation.
REFER ARTICLE ; https://www.sfmagazine.com/articles/2022/september/revenue-recognition-and-long-term-contracts/
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