- Summarize revenue recognition under GAAP
Under the cash basis of accounting, revenues are recognized when cash is received. Expenses are recognized when cash is paid out.
|Cash Basis||Accrual Basis|
|Revenues are recognized as cash is received||Revenues are recognized when earned (goods are delivered or services are performed).|
|Expenses are recognized as cash is paid||Expenses are recognized when incurred to produce revenues|
This concept sounds simple enough; however, for many years revenue recognition differed between GAAP and International Financial Reporting Standards (IFRS). GAAP was rule based and had complex, detailed, and disparate revenue recognition requirements for specific transactions and industries, such as software development, real estate, and construction. As a result, different industries used different accounting for economically similar transactions.
As part of the overall movement toward a more principles-based system like the IFRS, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606). This update established the principles to report useful information to users of financial statements about the nature, timing, and uncertainty of revenue from contracts with customers.
Rather than trying to make strict rules for each different industry, the FASB created a five-step process:
- Identify the Contract with a Customer
- Identify the Performance Obligations
- Determine the Transaction Price
- Allocate the Transaction Price to the Performance Obligations
- Recognize Revenue When or As Performance Obligations Are Satisfied
Step 1: Identify the Contract with a Customer
The application of this step will be straightforward for the majority of time. The contract or agreement will follow this guidance if the following criteria are met:
- Approved contract by both parties—Written or oral?
- Each party’s rights can be determined—Who’s doing what?
- Payment terms are identified—How much?
- Commercial substance exists—The transaction is worth something.
- Collection is probable—You will get paid for the sale.
Step 2: Identify the Performance Obligations
This step identifies what’s being delivered or provided to the customer. This step is one of the more significant rules because a contract can have more than one performance obligation, and each obligation will need to be specified. Another way to think about it is to consider if the customer can use or benefit from the good or service on its own. If they can, that is probably a separate performance obligation.
For example, a customer enters into an agreement to buy equipment with a year of free maintenance. There are two distinct performance obligations—the sale of the equipment and the year of maintenance.
Step 3: Determine the Transaction Price
When determining the price, there are a few things to consider and their effects:
- Variable Consideration—Estimated amount received after rebates, discounts, refunds, etc.
- Financing Component—Time value of money consideration if there is a financing component.
- Non-Cash Considerations—Items provided should be measured at fair value of what is received.
- Amounts Payable to Customer—In the contract, if anything is owed to the customer, the transaction price should be reduced by that amount.
Step 4: Allocate the Transaction Price to the Performance Obligations
If there are multiple performance obligations, the transaction price must be allocated to each performance obligation on a relative standalone basis.
The best way to do this is to compile each performance obligation’s stand-alone price if it were sold separately by the entity. If a stand-alone selling price is not directly observable, it must be estimated. Combine the stand-alone selling prices and allocate the transaction price proportionately to each performance obligation based on their respective standalone prices.
Step 5: Recognize Revenue When or As Performance Obligations Are Satisfied
Revenue will be recognized as the performance obligations are completed and control of the good or service is transferred to the customer. Control is considered to be transferred when the customer has the ability to direct the use of and receive benefit from the good or service.
In a retail environment, control is transferred upon the sale of the good, and revenue would be recognized at that time. If the performance obligation is transferred over time, like in a one-year maintenance contract, revenue will be recognized over the year as the performance obligations are completed.
Now that you have been introduced to the five-step process, we’ll now walk through journal entries for sales and payments on account using this process.