Demystifying Revenue Recognition
The When and How of recording Revenue and Income
Understanding Revenue Recognition
Revenue recognition refers to the process by which businesses record and report their earnings from the sale of goods or services. For businesses with a subscription model, revenue recognition becomes more complex as the revenue is recognized over a period of time rather than at the point of sale. This is because customers pay for the subscription upfront or in installments, and the business must allocate the revenue over the subscription period.
The 5 steps to Revenue Recognition
Step 1: Identify the contract with the customer
The first step is to identify and establish the contract. 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. The criteria of recognizing a contract shall be fulfilled.
Step 2: Identify your contractual Performance Obligations
The second step in recognizing revenue is to identify the performance obligations in the contract separately. Performance obligations represent the goods or services that the business has promised to deliver to the customer. These can be distinct, or a series of goods or services that are substantially the same and are thereby transferred in the same manner. In a subscription model, this could include access to a software platform, online content, or other services.
Step 3: Determine the overall Transaction Price
Next, the business needs to determine the transaction price, which is the amount of consideration it expects to receive in exchange for fulfilling the performance obligations. The transaction price may be a fixed amount or variable based on factors such as usage or add-on services. If the consideration is to be settled after a period of 1 year, the price should be discounted to arrive at revenue amount. Non-cash consideration to be valued at Fair Market value.
Step 4: Allocate the Transaction Price towards each obligation
Once the transaction price is determined, it needs to be allocated to each performance obligation. This is done based on the relative standalone selling prices of the goods or services being provided. If the standalone selling prices are not observable, estimation techniques like "the expected value" or "the most likely value" may be used. Discounts should be allocated proportionally, while any change in transaction price is to be allocated based on the same basis as inception.
Step 5: Recognize Revenue
With the transaction price allocated, the business can now recognize revenue either at a point in time or over a period of time. The revenue is generally recognized on a straight-line basis, meaning an equal amount is recognized in each reporting period. This ensures that revenue is recognized in a manner that reflects the transfer of goods or services to the customer over time. However, in some cases, Output methods or Input methods are used as well.
Journal Entries for Recognizing Revenue
Let us understand this with the help of an example here.
Facts: A software company enters into a $250,000 contract with a customer to transfer a software license, perform installation services, and provide technical support for a three-year period. The entity sells the license, installation service and technical support separately. The installation service and technical support could be performed by other entities and the software remains functional in the absence of these services. The contract price must be paid on installation of the software, which is planned for March 1, Year 1. Standalone selling prices of license is $160,000, installation service is $20,000 and technical support runs $30,000 per year. How should the software company recognize revenue for these transactions?
Solution: Allocating the revenue in proportion of the standalone prices -
Software License [($160,000/$270,000)*($250,000)] = $148,148
Installation Service [($20,000/$270,000)*($250,000)] = $18,519
Technical Support [($90,000/$270,000)*(250,000)] = $83,333
Now, the JE on the receipt of cash for the above transfer on march 1, Year 1 -
Cash Dr. $250,000
License Revenue Cr. $148,148
Service Revenue Cr. $18,519
Unearned Support Revenue Cr. $83,333
Revenue is recorded for the sale of the license and the installation at the time of sale. The technical support will be recognized on a monthly basis as the support is provided.
At year end, an adjusting entry is made to record 10 months of technical support ($83,333*10/36 = $23,148) through the end of Year 1. The remaining technical support will be recorded in Years 2,3 and 4.
Unearned Support Revenue Dr. $23,148
Support Revenue Cr. $23,148
Presentation
A Contract Asset or Liability should be presented in the statement of financial position when either party has performed the contract.
A Contract Asset reflects the entity's right to consideration in exchange for goods or services that the entity has transferred to the customer. Essentially the entity has performed prior to the customer paying or prior to the payment due date. The conditions associated with this right are something other than the passage of time.
A Contract Liability must be booked when an entity has an obligation to transfer goods or services to a customer. In this situation, the entity has either already received consideration from the customer or the customer owes consideration and it is unconditional (the customer pays or owes payment before the entity performs).
Facts: On January 1, Anderson Co. enters into a noncancelable contract with Tanner Co. for the sale of an excavator for $350,000. The excavator will be delivered to Tanner on April 1. The contract requires Tanner to pay the $350,000 in advance on Feb 1, while Tanner makes the payment on March 1. Journalize.
Solution:
Entry on Feb 1:
Receivable Dr. $350,000
Contract Liability Cr. $350,000
Entry on March 1:
Cash Dr. $350,000
Receivable Cr. $350,000
Entry on April 1:
Contract Liability Dr. $350,000
Revenue Cr. $350,000
Facts: On January 1, Anderson Co. enters into a noncancelable contract with Tanner Co. for the sale of an excavator for $350,000 each. The contract requires one excavator to be delivered on Feb 1 and states that the payment for the delivery of the first excavator is conditional on the delivery of the second excavator. The second excavator is delivered on June 1. Journalize.
Solution:
Entry on Feb 1: Anderson recognizes a contract asset and revenue when it satisfies the performance obligation to deliver the first excavator.
Contract Asset Dr. $350,000
Revenue Cr. $350,000
Entry on Jun 1: Anderson recognizes a receivable and revenue when it satisfies the performance obligation to deliver the second excavator.
Receivable a/c Dr. $700,000
Contract Asset a/c Cr. $350,000
Revenue a/c Cr. $350,000
ASC-606 vs IFRS 15
ASC-606 (Accounting Standards Codification) provides businesses with a universal framework for recognising revenue from customer sales. The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) released ASC 606 in May 2014 under US GAAPs.
IFRS 15 is a revenue-recognition standard for businesses’ contracts with customers for the purchase of goods or services. It applies to public, private, and nonprofit entities. Like ASC 606, the purpose of IFRS 15 is to eliminate inconsistencies in the way that entities across different industries approach accounting for similar financial transactions. These are internationally recognized and are issued by IASB(International Accounting Standards Board).
Both ASC 606 and IFRS 15 provide a comprehensive framework for recognizing revenue from customer contracts. They have similar underlying principles and objectives, and they both have the goal of ensuring consistency and comparability in financial reporting across different industries and geographic regions. But there are a few minor differences:
Cost Capitalization - ASC 606 allows companies to capitalize and amortize certain incremental costs of obtaining a contract, such as sales commissions, while in IFRS 15, the costs incurred must be expected to generate future economic benefits to be capitalized.
Scope - ASC 606 applies to all entities that enter into contracts with customers, while IFRS 15 excludes contracts in the scope of IFRS 17 Insurance contracts.
Disclosures - IFRS 15 includes additional requirements related to the nature, timing, and uncertainty of revenue and cash flows arising from customer contracts.
Presentation of Revenue - Under ASC 606, companies must present revenue in their income statement in a way that reflects the transfer of control of goods or services to the customer. But under IFRS 15, companies must present revenue in their income statements on a gross or net basis, depending on whether they are acting as a principal or an agent in the transaction.
This blog provides a general and brief overview of Revenue Recognition principles and is not intended as an accounting advice. It is essential to consult with a professional to discuss the specifics of your situation.
Let's conquer the world of Accounting together, one step at a time! You can reach out to the Numbreylla Team for any assistance.
Understanding Revenue Recognition
Revenue recognition refers to the process by which businesses record and report their earnings from the sale of goods or services. For businesses with a subscription model, revenue recognition becomes more complex as the revenue is recognized over a period of time rather than at the point of sale. This is because customers pay for the subscription upfront or in installments, and the business must allocate the revenue over the subscription period.
The 5 steps to Revenue Recognition
Step 1: Identify the contract with the customer
The first step is to identify and establish the contract. 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. The criteria of recognizing a contract shall be fulfilled.
Step 2: Identify your contractual Performance Obligations
The second step in recognizing revenue is to identify the performance obligations in the contract separately. Performance obligations represent the goods or services that the business has promised to deliver to the customer. These can be distinct, or a series of goods or services that are substantially the same and are thereby transferred in the same manner. In a subscription model, this could include access to a software platform, online content, or other services.
Step 3: Determine the overall Transaction Price
Next, the business needs to determine the transaction price, which is the amount of consideration it expects to receive in exchange for fulfilling the performance obligations. The transaction price may be a fixed amount or variable based on factors such as usage or add-on services. If the consideration is to be settled after a period of 1 year, the price should be discounted to arrive at revenue amount. Non-cash consideration to be valued at Fair Market value.
Step 4: Allocate the Transaction Price towards each obligation
Once the transaction price is determined, it needs to be allocated to each performance obligation. This is done based on the relative standalone selling prices of the goods or services being provided. If the standalone selling prices are not observable, estimation techniques like "the expected value" or "the most likely value" may be used. Discounts should be allocated proportionally, while any change in transaction price is to be allocated based on the same basis as inception.
Step 5: Recognize Revenue
With the transaction price allocated, the business can now recognize revenue either at a point in time or over a period of time. The revenue is generally recognized on a straight-line basis, meaning an equal amount is recognized in each reporting period. This ensures that revenue is recognized in a manner that reflects the transfer of goods or services to the customer over time. However, in some cases, Output methods or Input methods are used as well.
Journal Entries for Recognizing Revenue
Let us understand this with the help of an example here.
Facts: A software company enters into a $250,000 contract with a customer to transfer a software license, perform installation services, and provide technical support for a three-year period. The entity sells the license, installation service and technical support separately. The installation service and technical support could be performed by other entities and the software remains functional in the absence of these services. The contract price must be paid on installation of the software, which is planned for March 1, Year 1. Standalone selling prices of license is $160,000, installation service is $20,000 and technical support runs $30,000 per year. How should the software company recognize revenue for these transactions?
Solution: Allocating the revenue in proportion of the standalone prices -
Software License [($160k/$270k)*($250k)] = $148,148
Installation Service [($20k/$270k)*($250k)] = $18,519
Technical Support [($90k/$270k)*(250k)] = $83,333
Now, the JE on the receipt of cash for the above transfer on march 1, Year 1 -
Cash Dr. $250,000
License Revenue Cr. $148,148
Service Revenue Cr. $18,519
Unearned Support Revenue Cr. $83,333
Revenue is recorded for the sale of the license and the installation at the time of sale. The technical support will be recognized on a monthly basis as the support is provided.
At year end, an adjusting entry is made to record 10 months of technical support ($83,333*10/36 = $23,148) through the end of Year 1. The remaining technical support will be recorded in Years 2,3 and 4.
Unearned Support Revenue Dr. $23,148
Support Revenue Cr. $23,148
Presentation
A Contract Asset or Liability should be presented in the statement of financial position when either party has performed the contract.
A Contract Asset reflects the entity's right to consideration in exchange for goods or services that the entity has transferred to the customer. Essentially the entity has performed prior to the customer paying or prior to the payment due date. The conditions associated with this right are something other than the passage of time.
A Contract Liability must be booked when an entity has an obligation to transfer goods or services to a customer. In this situation, the entity has either already received consideration from the customer or the customer owes consideration and it is unconditional (the customer pays or owes payment before the entity performs).
Facts: On January 1, Anderson Co. enters into a noncancelable contract with Tanner Co. for the sale of an excavator for $350,000. The excavator will be delivered to Tanner on April 1. The contract requires Tanner to pay the $350,000 in advance on Feb 1, while Tanner makes the payment on March 1. Journalize.
Solution:
Entry on Feb 1:
Receivable Dr. $350,000
Contract Liability Cr. $350,000
Entry on March 1:
Cash Dr. $350,000
Receivable Cr. $350,000
Entry on April 1:
Contract Liability Dr. $350,000
Revenue Cr. $350,000
Facts: On January 1, Anderson Co. enters into a noncancelable contract with Tanner Co. for the sale of an excavator for $350,000 each. The contract requires one excavator to be delivered on Feb 1 and states that the payment for the delivery of the first excavator is conditional on the delivery of the second excavator. The second excavator is delivered on June 1. Journalize.
Solution:
Entry on Feb 1: Anderson recognizes a contract asset and revenue when it satisfies the performance obligation to deliver the first excavator.
Contract Asset Dr. $350,000
Revenue Cr. $350,000
Entry on Jun 1: Anderson recognizes a receivable and revenue when it satisfies the performance obligation to deliver the second excavator.
Receivable a/c Dr. $700,000
Contract Asset a/c Cr. $350,000
Revenue a/c Cr. $350,000
ASC-606 vs IFRS 15
ASC-606 (Accounting Standards Codification) provides businesses with a universal framework for recognising revenue from customer sales. The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) released ASC 606 in May 2014 under US GAAPs.
IFRS 15 is a revenue-recognition standard for businesses’ contracts with customers for the purchase of goods or services. It applies to public, private, and nonprofit entities. Like ASC 606, the purpose of IFRS 15 is to eliminate inconsistencies in the way that entities across different industries approach accounting for similar financial transactions. These are internationally recognized and are issued by IASB(International Accounting Standards Board).
Both ASC 606 and IFRS 15 provide a comprehensive framework for recognizing revenue from customer contracts. They have similar underlying principles and objectives, and they both have the goal of ensuring consistency and comparability in financial reporting across different industries and geographic regions. But there are a few minor differences:
Cost Capitalization - ASC 606 allows companies to capitalize and amortize certain incremental costs of obtaining a contract, such as sales commissions, while in IFRS 15, the costs incurred must be expected to generate future economic benefits to be capitalized.
Scope - ASC 606 applies to all entities that enter into contracts with customers, while IFRS 15 excludes contracts in the scope of IFRS 17 Insurance contracts.
Disclosures - IFRS 15 includes additional requirements related to the nature, timing, and uncertainty of revenue and cash flows arising from customer contracts.
Presentation of Revenue - Under ASC 606, companies must present revenue in their income statement in a way that reflects the transfer of control of goods or services to the customer. But under IFRS 15, companies must present revenue in their income statements on a gross or net basis, depending on whether they are acting as a principal or an agent in the transaction.