For some companies, revenue recognition is easy: Just count the money in the cash register at the end of the day. For others, it can be more complicated. When the exchange of goods and materials doesn’t match up with the receipt of revenue, it can create an accounting problem.
GAAP (Generally Accepted Accounting Principles) state that revenue and costs must be recognized in the same time period. This can be difficult when dealing with long-term contracts and projects. Luckily, there’s help. But before we get to the help, we’re going to look at what revenue recognition is, and the problems around it that occur for some companies.
What is revenue recognition?
Revenue recognition is defined as an accounting principle that determines when revenue can be recognized for accounting purposes. You would think revenue would be recognized when a sale is made, but often it’s not quite that simple.
Most companies that sell products are able to recognize their revenue when the customer pays for a product. However, companies that are involved in long-term contracts or provide a product or service over time need a way to recognize revenue as the contracts are completed.
Since many of these contracts can last months or years, companies can’t just wait until the end to record their income.
Recognizing accrued revenue versus deferred revenue
Accounting transactions can be recorded in two ways: a cash basis, or an accrual basis. Most large companies record their transactions on an accrual basis, which means income and expenses are recognized when they are incurred, not when cash changes hands.
Accrual accounting principles require that revenue be recognized when it’s realized and earned. According to GAAP, this is determined when the amount of goods or services delivered matches the amount that is expected by the customer. GAAP also requires that revenue and costs be reported in the same accounting period — usually the same month or year.
Based on these requirements, accrued revenue is goods or services that have been provided and billed to the customer but have not been paid yet. Most companies refer to accrued revenue as accounts receivable. This type of revenue can be recognized when the sale is made, not when payment is received.
Deferred revenue, on the other hand, occurs when payment is received before the goods or services have been provided. These are often referred to as deposits and are not recognized as income until the work has been completed.
When closing out accounting periods and reconciling accounts, accountants need to identify any deferred revenue showing in the accounts receivable and move it out of the reported income amounts.
The 5 steps to revenue recognition
In 2014 the Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards Foundation (IFRS) issued standards for recognizing revenue from contracts, called ASC 606. All companies that deal with long-term contracts must use this standard for determining when revenue is recognized.
The standard dictates a five-step process for recognizing revenue on contracts.
1. Identify the contract
The first step, identifying the contract, doesn’t seem too difficult. Contractors and suppliers should identify their open contracts to provide goods or services.
Change orders, which are changes to a contract after the contract has been executed, can be considered as part of an existing contract or as a new contract. Deciding which to choose is partially based on the second step.
2. Identify the performance obligations (milestones) of the contract
Next, we come to the crux of income recognition — performance obligations. As per IFRS 15 (the international standard, which is the same as ASC 606), “Performance obligations are promises in a contract to transfer to [a] customer goods or services that are distinct.”
Contracts may have more than one performance obligation, depending on how the work is identified.
For example, a contract may call for the construction of a building and a parking lot. The contract can be considered to have one performance obligation, or it can be broken into two separate ones, the building and the parking lot.
A good rule of thumb for separating performance obligations is to consider whether the customer can benefit from the delivery of the good or service on its own, or if they need the other parts of the contract to complete it.
In our example, the electrical work in the building could not be separated out as a distinct performance obligation because the owner can’t use the electrical without the rest of the building.
3. Determine the transaction price
Once the performance obligations have been identified for each contract, you’ll need to determine the transaction price. This is usually the contract value and may include pending change orders.
4. Allocate the transaction price to the performance obligations
Next the transaction price needs to be distributed to each performance obligation under that contract. Each performance obligation should have a price identified for the work or materials.
The ASC 606 guidance has contractors and suppliers do this based on the “relative standalone prices of each distinct good or service.”
5. Recognize revenue as the performance obligations are met
Finally, companies can recognize revenue once each performance obligation is completed. The question now becomes when a performance obligation is completed on a long-term contract.
ASC 606 defines completion as a transfer of control, which can be done over time or at a specific point in time, based on the contract terms. If a customer takes ownership of the goods or services as they are completed, income can be recognized as ownership progresses.
In construction, this is similar to percentage of completion revenue recognition. On the other hand, if the customer takes ownership at the moment of final completion, then revenue must be recognized at that point and not before. This is similar to completed contract revenue recognition in construction.
Examples of revenue recognition
Let’s look at a couple of examples of revenue recognition and how it’s calculated using the ASC 606 standard.
Example 1: Building 7 townhomes
Say we are building a group of seven townhomes and they are being built sequentially. The overall project is halfway complete, and three townhomes are finished and ready for move-in. The overall project contract is $2 million.
Let’s look at how our revenue should be reported.
1. Identify the contract: The entire contract for this project is $2 million.
2. Identify the performance obligations: For this example, we could do this two ways — as one large project containing all seven townhomes, or as individual units. Since three of the townhomes are completed and ready for ownership, we’ll split them into individual performance obligations, one for each townhome. So, in this contract, we have seven performance obligations.
3. Determine the transaction price: In this case, the transaction price is the amount of the contract — $2 million.
4. Allocate the transaction price to the performance obligations: To make this easy we are going to allocate the transaction price evenly over the seven units. This means each one is valued at $285,000.
5. Recognize revenue: Since three of the units are ready for ownership, we’re able to recognize the revenue from those units. $285,000 times three is $855,000. Note that the project is 50% complete, which means we could be recognizing $1 million in revenue, but because of the way we broke out the performance obligations, we can only recognize the completed units.
f we chose to lump the entire contract into one performance obligation and the owner took ownership as the work progressed, we could recognize $1 million in revenue at this time.
Example 2: Creating 500,000 widgets
Suppose that our company has been contracted to provide 500,000 widgets to the government. Each widget costs $1,000, so the total contract is $5 million. Widgets are being sent out in shipments of 25,000 and the government pays for each shipment after it is sent out. Let’s see how we recognize our income using ASC 606.
1. Identify the contract: The total contract is $5 million.
2. Identify the performance obligations: In this case, since widgets are being sent out as manufacturing progresses, the owner takes control every time a shipment is sent. So, a performance obligation can be defined as 25,000 widgets. There are 20 performance obligations in this contract.
3. Determine the transaction price: The government just added another 50,000 widgets, for a total change order of $500,000. The transaction price is now $5.5 million.
4. Allocate the transaction price to the performance obligations: 25,000 widgets at $1,000 apiece is $250,000. Each performance obligation completed creates $250,000 in revenue.
5. Recognize revenue: If 25,000 widgets have been shipped, then we can recognize $250,000 in revenue. If we have completed another 25,000 widgets but haven’t shipped them yet, we can’t recognize any income for those widgets. Once the second set of widgets have been shipped, we’ll be able to recognize $500,000 in revenue.
Timing is everything when recognizing revenue
Revenue recognition is complicated when it comes to long-term contracts. Companies need to analyze each of their contracts to assure that the income is being recognized at the correct time. Thankfully, ASC 606 provides guidance for companies on how to allocate contracts and when to recognize the income on those contracts.