What is Revenue Recognition?
Revenue recognition is a generally accepted accounting principle (GAAP) that determines the specific conditions in which revenue is recognized or accounted for. Generally, revenue is recognized only when a critical event has occurred, and the amount of revenue is measurable. However, there are several situations in which exceptions may apply.
Breaking Down Revenue Recognition
Revenue is at the heart of business performance. Everything hinges on the sale. As such, regulators know how tempting it is for companies to push the limits on what qualifies as revenue, especially when not all revenue is collected when the work is done. Attorneys often bill clients in billable hours and present the invoice after work is completed. Construction managers often bill clients on a percentage-of-completion method. As a result, analysts like to know that revenue recognition policies for a company are relatively standard for the industry. This also helps to ensure an apples-to-apples comparison is made between metrics using line items from the income statement.
Revenue Recognition Requirements
The revenue recognition principle, a combination of accrual accounting and the matching principle, stipulates that revenues are recognized when realized and earned, not necessarily when received. Realizable means that goods and/or services have been received, but payment for the goods and/or services is expected later. Earned revenue accounts for goods and/or services that have been provided or performed, respectively. In addition, the revenue generating activity must be fully or primarily complete to include its revenue during the respective accounting period, and there must be a reasonable level of certainty that earned revenue will be received. Lastly, according to the matching principle, the revenue and its associated costs must be reported in the same accounting period.
GAAP Changes to Revenue Recognition Policies
On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606, regarding revenue from contracts with customers. ASC 606 provides a uniform framework for recognizing revenue from contracts with customers. The old guidance was industry-specific, which created a system of fragmented policies. The new guidance is industry-neutral and, therefore, more transparent. The core principle of ASC 606 is that revenue is recognized when the delivery of promised goods and/or services matches the amount of consideration expected in exchange for the goods and/or services. There are five steps that allow the recognition of revenue under that core principle:
- Identify the contract
- Identify the contractual performance obligations
- Determine the amount of consideration/price for the transaction
- Allocate the determined amount of consideration/price to the contractual obligations
- Recognize revenue when or as the performing party satisfies performance obligations