Case Study
Beyond Materiality: Streamlining Contract Review Through A Risk Based Approach Featuring Intercom

Five Steps of

Revenue Recognition

In revenue accounting, we are constantly hearing about “the 5 steps of revenue recognition”. This 5 step process stems from guidance developed by the FASB. Let’s explore the reasoning behind the development of ASC 606 Revenue from Contracts with Customers as well as take a deep dive into the 5 steps and what they mean.

Five Steps of

Revenue Recognition

In revenue accounting, we are constantly hearing about “the 5 steps of revenue recognition”. This 5 step process stems from guidance developed by the FASB. Let’s explore the reasoning behind the development of ASC 606 Revenue from Contracts with Customers as well as take a deep dive into the 5 steps and what they mean.

Five Steps of

Revenue Recognition

In revenue accounting, we are constantly hearing about “the 5 steps of revenue recognition”. This 5 step process stems from guidance developed by the FASB. Let’s explore the reasoning behind the development of ASC 606 Revenue from Contracts with Customers as well as take a deep dive into the 5 steps and what they mean.

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The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). As stated by the joint parties, the goals of the project were to:

  1. Remove inconsistencies and weaknesses in revenue requirements.
  2. Provide a more robust framework for addressing revenue issues.
  3. Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
  4. Provide more useful information to users of financial statements through improved disclosure requirements.
  5. Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.

To that end, in May 2014, the FASB and the IASB issued joint documents, Accounting Standards Update 2014–09 Revenue from Contracts With Customers (Topic 606) and International Financial Reporting Standard 15 (IFRS 15) which converged the standards of the two boards.

The core principle of the guidance is that companies should recognize revenue in line with the transfer of goods or services to customers in an amount that the company expects to be entitled to in exchange for those goods or services. The 5 steps used to satisfy this core principle are:

Step 1: Identify the contract(s) with a customer.

Step 2: Identify the performance obligations in the contract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the performance obligations in the contract.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

Let’s dig into each of these steps in a little more detail

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The core principle of the guidance is that companies should recognize revenue in line with the transfer of goods or services to customers in an amount that the company expects to be entitled to in exchange for those goods or services.

Step 1: Identify the Contract with a Customer

A contract is an agreement between two or more parties that creates enforceable rights and obligations. ASC 606 / IFRS 15 should be applied for contracts that meet the following criteria:

  1. Both parties have approved and committed to the contract
  2. The rights of the parties are identified
  3. Payment terms are identified
  4. The contract has commercial substance
  5. It’s probable that the company will collect the consideration to which it will be entitled in exchange for the goods or services.

Other considerations for identifying a contract with a customer are the combining of contracts and contract modifications.

Step 2: Identify the Performance Obligations in the Contract

A performance obligation is a promise in a contract with a customer to transfer a good or service to that customer. If a company promises to transfer more than one good or service to the customer, the company should account for each good or service as a performance obligation if it is distinct or is a series of distinct goods or services that are substantially the same and have the same pattern of transfer.

A good or service is distinct if the customer can benefit from the good or service on its own or together with other resources that are available to them and the promise to transfer the good or service is separately identifiable from other promises in the contract.

If a good or service is not identified as distinct, it should be combined with other goods and services in the contract until a bundle of goods is identified that is distinct.

Step 3: Determine the Transaction Price

The transaction price is the amount of consideration to which the company will be entitled in exchange for the goods or services. Effects of the following could impact the transaction price for a contract with a customer:

  1. Variable consideration — If the amount of consideration in a contract is variable, the company should determine the amount to include in the transaction price by making an estimate based on one of two methods: (1) expected value or (2) the most likely amount.
  2. Constraining estimates of variable consideration — If there is a constraint to estimate the variable consideration, the company should only account for consideration that the company is confident will not result in a significant reversal of revenue once the constraint is lifted.
  3. The existence of a significant financing component — If the customer or the company receive a significant benefit of financing for the transfer of goods and services, this must be factored into the transaction price. Contracts that have a term of one year or less don’t have to be considered for significant financing.
  4. Noncash consideration — If a customer promises consideration in a form other than cash, the customer should measure the noncash consideration as such and apply the value to the transaction price.
  5. Consideration payable to the customer — If the company pays, or expects to pay, consideration to a customer that the customer can apply against amounts owed to the company, the company should reduce the transaction price or account for the consideration as a payment for a distinct good or service (or both).

Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract

For a contract that has more than one performance obligation, the company should allocate the transaction price to each performance obligation based on the amount expected to be received for each performance obligation.

To allocate an appropriate amount of consideration to each performance obligation, the company will determine the standalone selling price (or fair value) of the goods and services identified in each performance obligation at contract inception and use this as a basis to perform a relative allocation of the transaction price. If a standalone selling price cannot be observed, it must be estimated. If the transaction price includes a discount or variable consideration that relates to one or more performance obligations, they should be allocated to the applicable performance obligations rather than to all.

If the transaction price changes throughout the contract term due to the lifting of a constraint to variable consideration or for any other reason, the addition or reduction in transaction price value should be allocated on the same basis as at contract inception. If this allocation results in an amount assigned to a previously satisfied performance obligation, revenue should be recognized in the period in which the transaction price changes.


Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation

A company should recognize revenue when it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when the customer obtains control of that good or service.

A performance obligation can be satisfied in two ways: (1) over time or (2) at a point in time. If an entity transfers a good or service over a period of time, over time recognition is appropriate. Otherwise, point in time recognition is used.

The criteria for satisfying a performance obligation over time as depicted in the guidance are:

  1. The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
  2. The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
  3. The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.

For over time recognition, the company should apply a method of measuring progress toward complete satisfaction of the performance obligation by using output or input methods. The measurement of progress should be updated from time to time as circumstances of the transaction change.

For all other performance obligations, in order to determine the point in time at which a customer obtains control, the company should use indicators of the transfer of control, which, as per the guidance, include, but are not limited to, the following:

  1. The entity has a present right to payment for the asset.
  2. The customer has legal title to the asset.
  3. The entity has transferred physical possession of the asset.
  4. The customer has the significant risks and rewards of ownership of the asset.
  5. The customer has accepted the asset.

Once the appropriate criteria have been met, point in time recognition can take place.

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