An Introduction to Recognizing Revenue from Contracts with Customers
By Danny Wong
Recognizing revenue is a vital part of the accounting process, and your ability to record revenue accurately, consistently, and appropriately impact every aspect of your operations.
The Guiding Principle of Revenue Recognition
Like all accounting principles, standardized methods for recording revenue were created to increase transparency and foster a fair market environment. Observers must be able to look at a company’s books and be confident that the figures being reported mean the same thing as they would for any of its competitors.
For a moment, imagine a world where no such standards existed. Your company receives an inquiry from a prospect about a large order that would put you on the map, and they tell you they are working on getting the cash together for a purchase. Despite the fact that a price and amount have not been agreed upon, and no actual work has been done to fulfill the purchase, you decide to go ahead and record some estimated revenue because you trust that the buyer will come through.
Suddenly, investors and analysts are looking at your company in a completely different way. But what if the sale falls through?
That is just one reason why maintaining standards for revenue recognition on contracts is so important. Agreements can mean many things to many people, and malicious companies try to find ways to over- or under-report revenue to improve their situation. That’s why specific, observable criteria must be met before you can count revenue as earned. With the proper conventions in place it is less likely that people will make mistakes that could confuse observers, and it is more difficult for unscrupulous people to cheat the system to their advantage.
Accountants and regulators place a great deal of importance on revenue recognition because it is the origination point of many financial indicators and a key financial indicator on its own. The amount of revenue earned is used to determine net income, available cash, and tax liabilities. When the amount of revenue recognized on the books is significantly inaccurate, it sends ripples throughout all segments of the organization.
The Basics of the New Standard Revenue from Contracts with Customers
The Financial Accounting Standards Board (FASB) is the group responsible for outlining the Generally Accepted Accounting Principles (GAAP), which covers U.S.-based companies. In 2014, the FASB and the International Accounting Standards Board (IASB), which determines the International Financial Reporting Standards (IFRS), jointly created a new set of standards governing revenue recognition from contracts with customers.
The new principles went into effect for all financial reporting periods after January 1, 2018. They are intended to standardize the process across multiple industries and ensure that financial disclosures meet an objective set of criteria. Before the new standard for revenue recognition, companies often relied on methods that were specific to their industry or tied to certain kinds of transactions. Companies have been able to use the new revenue recognition standard for reporting since it was unveiled in 2014, and it is now mandatory for all financial reporting.
At the heart of the FASB and IASB joint revenue recognition standard is a five-step process that determines when a valid contract is in effect and the officers of the company can recognize revenue from it. Certain obligations must be satisfied before revenue is considered valid, and the five-step process outlined by the FASB and IASB is intended to give companies a simple framework they can follow to ensure these obligations are met every time.
A Brief Primer on Contracts
Before getting into the details of the new standard revenue from contracts with customers, it will help to specify what a contract is and what it isn’t. Many people without a legal background often have a vague idea in their head of what constitutes a contract, but may not understand the actual components that must be present in order for a contract to be valid and enforceable.
Essentially, a contract is an agreement between two or more parties to perform some kind of act, or, in rare cases, to not do something. Contracts are legally enforceable as long as they contain all the necessary elements for validity.
All contracts have to be based on some kind of offer. The offer can take many different forms, including a product, service, action, or other. Once the offer has been established, another party must accept that offer. After acceptance, the accepting party then offers something else of value, which is known as consideration. In business settings, of course, the consideration is typically a monetary payment for the product or service, but it can be anything that has value to the seller.
When these criteria have been established, the parties involved in the contract must signal their intent to enter into a legally binding agreement. They have to show that they are aware they are entering into a contract. It’s important to note that while most contracts are written, verbal contracts that contain all these elements are also legally binding.
Following the Five-Step Model for Recognizing Revenue
The FASB and IASB created a five-step process for recognizing revenue from contracts with customers. Once all of these steps have been completed, the revenue can be reasonably assumed to be earned and recorded. The steps are as follows:
1. Identify a contract.
Essentially, the elements of a contract must be present in order for you to recognize revenue. The contract can be verbal or written, but the criteria must be satisfied.
2. Identify performance obligations in the contract.
Determine what you are responsible for providing to the buyer as outlined in the contract. In other words, you can’t recognize revenue if you don’t know exactly what it is for.
3. Set transaction price.
This is similar to determining the consideration in the contract. Make sure both parties agree on what the seller will receive for the performance obligations.
4. Allocate transaction price.
Specific amounts of revenue have to be directly attributable to goods and services on the general ledger. As a revenue from contracts with customers example, if you sign a contract agreeing to install a security system package for a set price, then revenue amounts must be allocated to each element of the package individually.
5. Recognize revenue.
Once you and the other party have satisfied these conditions, then you can record the revenue in the general ledger.
Additional Revenue Recognition Concerns
You must be able to record revenue accurately in order to monitor your cash on hand, forecast, determine budgets, assess your tax liability, and more. It is the base of the entire financial picture of the organization. This five-step plan is important because it makes the process more transparent for companies and gives them a simple template to follow for addressing questions about revenue. When you have questions about whether or not revenue is valid, you can refer to the steps to determine if you have fulfilled all of the necessary obligations.
Many companies are not going to collect 100% of their revenue. However, you should be relatively assured that you are going to collect most of it. When it is in doubt as to whether or not you will collect any of the revenue from a sale, even if all parts of the five-step plan have been completed, then you should refrain from recording the revenue until you collect payment.
In closing, remember that revenue and cash are not equal, and that recognizing revenue does not mean you will get paid immediately or completely. There are plenty of companies logging large amounts of revenue that are in precarious cash positions. Likewise, there are some companies that can sell very little during a period and operate entirely off their rich cash reserves. Regardless, accurate reporting is key, and doing so according to the new revenue recognition principle will help your company in the long run.
