What is Revenue Recognition?
Revenue recognition is an accounting principle that outlines the specific conditions under which revenue is recognized. In theory, there is a wide range of potential points at which revenue can be recognized. This guide addresses recognition principles for both IFRS and U.S. GAAP.
Conditions for Revenue Recognition
According to the IFRS criteria, for revenue to be recognized, the following conditions must be satisfied:
- Risks and rewards of ownership have been transferred from the seller to the buyer.
- The seller does not have control any longer over the goods sold.
- The collection of payment from goods or services is reasonably assured.
- The amount of revenue can be reasonably measured.
- Costs of revenue can be reasonably measured.
Conditions (1) and (2) are referred to as Performance. Regarding performance, it occurs when the seller has done what is to be expected to be entitled to payment.
Condition (3) is referred to as Collectability. The seller must have a reasonable expectation that he or she will be paid for the performance.
Conditions (4) and (5) are referred to as Measurability. Due to the accounting guideline of the matching principle, the seller must be able to match the revenues to the expenses. Hence, both revenues and expenses should be able to be reasonably measured.
Revenue Recognition from Contracts
IFRS 15, revenue from contracts with customers, establishes the specific steps for revenue recognition. It is important to note that there are some exclusions from IFRS 15 such as:
- Lease contracts (IAS 17)
- Insurance contracts (IFRS 4)
- Financial instruments (IFRS 9)
Steps in Revenue Recognition from Contracts
The five steps for revenue recognition in contracts are as follows:
1. Identifying the Contract
All conditions must be satisfied for a contract to form:
- Both parties must have approved the contract (whether it be written, verbal, or implied).
- The point of transfer of goods and services can be identified.
- Payment terms are identified.
- The contract has commercial substance.
- Collection of payment is probable.
2. Identifying the Performance Obligations
Some contracts may involve more than one performance obligation. For example, the sale of a car with a complementary driving lesson would be considered as two performance obligations – the first being the car itself and the second being the driving lesson.
Performance obligations must be distinct from each other. The following conditions must be satisfied for a good or service to be distinct:
- The buyer (customer) can benefit from the goods or services on its own.
- The good or service is separately identified in the contract.
3. Determining the Transaction Price
The transaction price is usually readily determined; most contracts involve a fixed amount. For example, a price of $20,000 for the sale of a car with a complementary driving lesson. The transaction price, in this case, would be $20,000.
4. Allocating the Transaction Price to Performance Obligations
The allocation of the transaction price to more than one performance obligation should be based on the standalone selling prices of the performance obligations.
For example, a contract involves the sale of a car with a complementary driving lesson. The total transaction price is $20,000. The standalone selling price of the car is $19,000 while the standalone selling price of the driving lesson is $1,000. The transaction price allocation would be as follows:
Note: The percentage of the total is simply the standalone price divided by the total standalone price. For example, the percentage of total for the car would be calculated as $19,000 / $20,000 = 95%.
5. Recognizing Revenue in Accordance with Performance
Recall the conditions for revenue recognition. Conditions (1) and (2) state that revenue would be recognized when the seller has done what is expected to be entitled to payment. Therefore, revenue is recognized either:
- At a point in time; or
- Over time
In the example above, the revenue associated with the car would be recognized at the point in time when the buyer takes possession of the car. On the other hand, the complementary driving lesson would be recognized when the service is provided.
The revenue recognition journal entries for the two performance obligations (car and driving lesson) would be as follows:
For the sale of the car and complimentary driving lesson:
Note: Revenue is recognized for the sale of the car ($18,050) but not for the complementary driving lesson because it has not yet been provided.
When the complementary driving lesson has been provided:
Note: Revenue is deferred until the driving lesson has been provided.
GAAP Revenue Recognition Principles
The Financial Accounting Standards Board (FASB) which sets the standards for U.S. GAAP has the following 5 principles for recognizing revenue:
- Identify the customer contract
- Identify the obligations in the customer contract
- Determine the transaction price
- Allocate the transaction price according to the performance obligations in the contract
- Recognize revenue when the performance obligations are met
Learn more about the principles on FASB’s website.
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