What is the Revenue Recognition Principle?
Under the Revenue Recognition Principle, revenue must be recorded in the period when the product or service was delivered (i.e. “earned”) – whether or not cash was collected from the customer.
Revenue Recognition Principle: Accrual Accounting Concept
According to the criteria established by U.S. GAAP, revenue can only be recognized once it has been earned under accrual basis accounting standards.
In short, the revenue recognition principle states that revenue is required to be recognized on the income statement in the period that the products/services were delivered, rather than when the cash payment is received.
Other considerations regarding when and if to recognize revenue are:
- The payment must be reasonably collectible (i.e. expected to be received from the customer).
- The price must be identified and measurable by both parties in the transaction.
- There must be evidence showing that an arrangement was agreed upon.
- The product or service obligation must be completed per the agreement.
How Revenue Recognition Works (FASB / IASB)
The Financial Accounting Standards Board (FASB), in a joint effort with the International Accounting Standards Board (IASB), recently announced an updated revenue recognition standard in ASC 606.
The purpose of refining the prior revenue policies was to improve the comparability among the financial statements of different companies and create a more consistent, standardized financial reporting process across all industries.
ASC 606 FASB and IASB Rationale
Joint Objective of ASC 606 Update (Source: ASC 606)
In theory, investors could line up the financial statements of different companies to assess their relative performance more accurately.
Prior to ASC 606, there were variations in how companies in different industries handled accounting for otherwise similar transactions.
The apparent lack of standardization made it difficult for investors and other users of financial statements to make comparisons between companies, even those operating in the same industry.
Revenue Recognition Concept: Illustrative Example (“Earned”)
Suppose a service-oriented company has generated $50,000 in credit sales in the past month.
Per the revenue recognition principle, the company must recognize the revenue on its income statement as soon as the service was provided to customers.
From the date of the initial sale to the date that the customer pays the company in cash, the unmet amount remains on the balance sheet as accounts receivable.
In a different scenario, let’s say the company was paid $150,000 upfront for three months of services, which is the concept of deferred revenue.
Each month when the company delivers the service, $50,000 will be recognized on the income statement.
But until the company earns the revenue, the payment received ahead of time is recorded as deferred revenue on the liabilities section of the balance sheet.
Revenue Recognition: ASC 606 Five-Step Process
The revenue recognition principle under ASC 606 states that revenue can only be recognized if the contractual obligations are met, as opposed to when the payment is made.
The ASC 606 standard comes down to a five-step process, with each guideline strictly required for revenue recognition:
- Identify the Contract with the Customer – All parties must approve the agreement and commit to fulfilling their obligation, with each party’s rights and payment terms clearly identified.
- Identify the Contractual Performance Obligations – In the 2nd step, the distinct performance obligations to transfer goods or services to the customer must be identified.
- Determine the Transaction Price – The transaction price (i.e. the total cash and non-cash consideration that the receiver is entitled to receive from the customer) must be outlined, alongside any variable considerations (e.g. discounts, rebates, incentives).
- Allocate the Transaction Price – Guidelines must be established for the allocation of the transaction price across the contract’s separate performance obligations (a break-down of the specific amounts that the customer agrees to pay for each good/service).
- Recognize Revenue – Once the performance obligations are satisfied (i.e. fulfilled), the revenue has been “earned” and is thereby recognized on the income statement.
ASC 606 standardized and brought a more rigid structure that public and private companies were required to follow in their revenue recognition processes.
In particular, the changes affected the amount and timing considerations of companies with subscription-based, long-term customer contracts.
With that said, ASC 606 was not as impactful to certain industries that produce revenue in one-time payments (e.g. retail), but the ramifications were more profound for companies reliant on recurring services like subscription fees and licenses (e.g. software, D2C).
Subscription Company Revenue Recognition Example
Unique to subscription models, customers are presented with a multitude of payment methods (e.g. monthly, quarterly, annual), rather than one-time payments.
ASC 606 separated each specific contractual obligation with a company’s pricing to define how revenue is recognized.
Let’s say that there’s a company with a subscription-based business model looking to assess how its revenue recognition processes are impacted by ASC 606.
Here, our subscription company charges $20 a month to send its products to its subscribers, as well as a one-time $40 onboarding fee as a part of the subscription program.
Following the completion of the initial onboarding stage, the $40 can be recognized by the company as revenue. However, the recurring $20 monthly fee is charged on the first day of each month despite the product itself not being delivered until a couple of weeks later into the month.
During the lag between the date when the customer was charged and the eventual delivery of the product, the company cannot recognize the $20 recurring payment as revenue until it has been “earned” (i.e. delivered).
Deferred Revenue Concept
Deferred revenue, also referred to as “unearned” revenue, refers to payments received for a product or service but not yet delivered to the customer. The cash payment from the customer was therefore received in advance for an expected benefit in the near future.
But under accrual accounting, an upfront cash payment cannot be recognized as revenue just yet – instead, it’s recognized as deferred revenue on the balance sheet until the obligation is delivered.
Types of Revenue Recognition Methods
A couple of other revenue recognition methods are:
- Percentage of Completion Method: Most Applicable for Long-Term Contractual Arrangements
- Completed-Contract Method: Revenue is NOT Recognized Until All Obligations are Fulfilled
- Cost Recoverability Method: Most Appropriate for Long-Term Contracts with Unpredictable Collections Amounts (i.e. Cannot Estimate Accurately)
- Installment Method: More Common for High Priced Purchases such as Fixed Assets and Real Estate with Unreliable Buyer Payments
Accounts Receivable vs. Deferred Revenue (“Unearned”)
Accounts receivable (A/R) is defined as sales made on credit in which the customer has not fulfilled their obligation to pay the company.
The sale is recorded in the company’s income statement, but the unmet customer payment appears as accounts receivable on the balance sheet until the customer pays the company.
Hence, the income statement must be supplemented by the cash flow statement (CFS) and balance sheet in order to understand what is actually occurring to a company’s cash balance.
The CFS reconciles revenue into cash revenue, whereas the accounts receivable carrying value can be found on the balance sheet.
A company generates more free cash flow (FCF) and is likely to be run more efficiently if its accounts receivables are kept to a minimum.
A low A/R balance implies the company can collect unmet cash payments quickly from customers that paid on credit while a high A/R balance indicates the company is incapable of collecting cash from credit sales.
- Increase in Accounts Receivable → Less Free Cash Flows (FCFs)
- Decrease in Accounts Receivable → More Free Cash Flows (FCFs)
Until the customer pays the company for the goods/services already received, the sale sits on the balance sheet as accounts receivable.
The opposite of accounts receivable is deferred revenue, i.e. “unearned” revenue, which represents cash payments collected from customers for products or services not yet provided.
The cash payment was already received upfront, so all that remains is the company’s obligation to hold up its end of the transaction – hence, its classification as a liability on the balance sheet.
But because the revenue is yet to be earned, the company cannot recognize it as a sale until the good/service is delivered.
The most common examples of deferred revenue are gift cards, service agreements, or rights to future software upgrades from a product sale.