Revenue Recognition: What It Means in Accounting and the 5 Steps

What Is Revenue Recognition?

Revenue recognition is a generally accepted accounting principle (GAAP) that identifies the specific conditions in which revenue is recognized and determines how to account for it. Revenue is typically recognized when a critical event has occurred, when a product or service has been delivered to a customer, and the dollar amount is easily measurable to the company.

Understanding Revenue Recognition

Revenue is at the heart of all business performance. Regulators know how tempting it is for companies to push the limits on what qualifies as revenue, especially when not all revenue is collected when the work is complete. For example, attorneys charge their clients in billable hours and present the invoice after work is completed. Construction managers often bill clients on a percentage-of-completion method.

The revenue recognition principle, a feature of accrual accounting, requires that revenues are recognized on the income statement in the period when realized and earned—not necessarily when cash is received. 

• Realized revenue means that goods or services have been received by the customer, but payment for the good or service is expected later.
• Earned revenue accounts for goods or services that have been provided or performed, respectively.

The revenue-generating activity must be fully or essentially complete for it to be included in revenue during the respective accounting period. Also, there must be a reasonable level of certainty that earned revenue payment will be received. Lastly, according to the matching principle, the revenue and its associated costs must be reported in the same accounting period.

Accounting for Revenue

Revenue accounting is fairly straightforward when a product is sold and the revenue is recognized when the customer pays for the product. However, accounting for revenue can get complicated when a company takes a long time to produce a product. As a result, there are several situations in which there can be exceptions to the revenue recognition principle.

Analysts, therefore, prefer that the revenue recognition policies for one company are also standard for the entire industry. Having a standard revenue recognition guideline helps to ensure that an apples-to-apples comparison can be made between companies when reviewing line items on the income statement. Revenue recognition principles within a company should remain constant over time as well, so historical financials can be analyzed and reviewed for seasonal trends or inconsistencies.

Accounting Standards Codification (ASC) 606

On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606. This highlights how revenue from contracts with customers is treated, providing a uniform framework for recognizing revenue from this source.

The old guidance was industry-specific, which created a system of fragmented policies. The updated revenue recognition standard is industry-neutral and, therefore, more transparent. It allows for improved comparability of financial statements with standardized revenue recognition practices across multiple industries.

There are five steps needed to satisfy the updated revenue recognition principle:

1. Identify the contract with the customer. This involves agreeing on the terms of the contract, including payment, the delivery of goods and services, and consequences if any obligations aren't met. Contracts may come in written form or may begin as verbal agreements.
2. Identify contractual performance obligations. In this case, it's important to outline the specific goods or services behind the agreement.
3. Determine the amount of consideration/price for the transaction. This isn't just about the price of goods and services but also includes other factors, such as discounts, return policies, and additional fees.
4. Allocate the determined amount of consideration/price to the contractual obligations. This step involves any specific selling price to every single obligation.
5. Recognize revenue when the performing party satisfies the performance obligation. This should only be done once the transaction is complete and your obligation is fulfilled. Revenue can only be recognized once this is done.

IFRS Reporting Criteria

There are certain conditions that businesses must meet as per IFRS requirements. According to the IFRS, these requirements fall into three different categories that are needed for contracts to exist. The table below highlights each one:

Performance indicates the seller has fulfilled a majority of their expectations in order to get payment. Collectability refers to the seller's expectation to be paid. Measurability, on the other hand, relates to the matching principle wherein the seller can match the expenses with the money earned from the transaction.

GAAP Revenue Recognition Principles

Generally accepted accounting principles require that revenues are recognized according to the revenue recognition principle, which is a feature of accrual accounting. This means that revenue is recognized on the income statement in the period when realized and earned—not necessarily when cash is received.

The revenue-generating activity must be fully or essentially complete for it to be included in revenue during the respective accounting period. Also, there must be a reasonable level of certainty that earned revenue payment will be received. Lastly, according to the matching principle, the revenue and its associated costs must be reported in the same accounting period.

The Bottom Line

Revenue is a key metric for any business. Certain businesses must abide by regulations when it comes to the way they account for and report their revenue streams. Public companies in the U.S. must abide by generally accepted accounting principles, which sets out principles for revenue recognition. This prevents anyone from falsifying records and paints a more accurate portrait of a company's financial situation.