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Dissecting the Revenue Recognition Principle

Accounting News

November, 2022

Dissecting the Revenue Recognition Principle

What is Revenue Recognition PrincipleSome businesses, especially publicly traded ones, may choose accrual accounting to reduce volatility in earnings, while start-ups or small businesses may choose to go with a cash basis accounting option. A poll conducted by the Journal of Accountancy on Topic 606 discovered that one in five respondents reported that one of the most common audit perils for their clients was the risk of evaluating “material misstatement” when it comes to recognizing revenue under Topic 606.

According to the Association of International Certified Professional Accountants (AICPA) and the Financial Accounting Standards Board's (FASB) Accounting Standards Topic 606, proper revenue recognition involves following five steps. While each step requires exercising judgment, the following is a brief overview.

Step 1

When all the following criteria is satisfied in the first step to establish a contract with their client, an organization should follow the revenue recognition standard mandates when an agreement falls within such criteria.  

All contract parties have agreed to the terms of the contract and are engaged in fulfilling their agreed-to commitments. All party's rights are easily identifiable when it comes to goods/services to be exchanged. Payment is clearly described for the goods/services to be delivered. The recipient's cash flows are expected to change based upon the contract's deliverables. The organization that provides the product or service should have “a reasonable expectation” of receiving consideration from the customer and they have a reasonable expectation the customer is able and willing to provide such payment.

Step 2

The second step is to determine what each party of the contract must fulfill to satisfy their respective contractual obligations. This is what businesses pledge to customers and clients while delivering their unique product or service. This step is where each performance obligation should be identified as unique. If each performance obligation does not qualify as unique, based upon this standard, it must be packaged with other goods or services until it meets such criteria.

The FASB AICPA ASC 606 standards explains if both of the following apply, a good or service is considered “distinct:”

If the receiving party can receive a useful product or professional assistance by itself or in conjunction with related materials the client had pre-existing to the contract in question;

AND

The business' contractual pledge to deliver the service or finished materials is individually distinguishable from additional pledges from the contract.

Step 3

The third step is to calculate the financial terms of the deal. This entails how much money the business anticipates receiving in return for delivering the goods or services, minus portions related to that of external organizations. This can include taxes businesses must collect for local, state or federal government agencies. Other examples of this include "variable consideration" – or how much consideration a company will receive bearing in mind financial adjustments in conjunction with delivering their product or service. Businesses should estimate the impact of such variable costs and what they might be allowed while fulfilling their contractual obligations. Examples can include financial enticements, fines, reimbursements, price cuts, etc.

Step 4

The fourth step is to figure out how much it will cost parties to fulfill their responsibilities spelled out in the legal agreement. When attempting to recognize revenue according to Topic 606, if there's multiple distinct responsibilities, the business is required to break down the price based on "each separate performance obligation in an amount" that is commensurate to an amount the business is expected to receive for each "separate performance obligation.” This means looking at each piece of the contract as a unique "performance obligation.”

When the transaction is subject to a discount or "variable consideration," businesses may or may not assign the price concession or "variable consideration" to one or more performance obligations, versus across the agreement's full list of "performance obligations." If the business offers markdowns of the goods or services, in addition to adjusting the "transaction prices," there should be proportional and estimated calculations when it comes to recognizing revenue.

Step 5

The fifth step says that once a business has satisfied its "performance obligation" set out in the contract, revenue can be recognized. This occurs when the customer receives their contracted goods or services, which is when they have complete command of the property. This can be illustrated when the customer can increase their cash flow, use it as an asset to obtain financing, leverage pre-existing equipment or service delivery, etc.

When it comes to recognizing revenue under Topic 606, this is just the beginning of how businesses can analyze and interpret the many nuances of this accounting topic.

 

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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