What is Revenue Recognition?

Revenue recognition is the process of recording revenue in the accounting records when it is earned and realizable, not necessarily when cash is received. Under the ASC 606 standard, revenue is recognized when control of a promised good or service is transferred to the customer. This transfer can occur either over time or at a specific point in time, depending on the nature of the performance obligation. The amount of revenue recognized must reflect the consideration the entity expects to receive in exchange for those goods or services. Proper revenue recognition ensures that financial statements accurately reflect a company’s financial performance.

What are the 5 Criteria for Revenue Recognition?

Revenue recognition criteria must be met in order to recognize the revenue associated with a sale transaction. Otherwise, recognition must be deferred until a later period when the criteria can be met. The following criteria have been developed by the Securities and Exchange Commission (SEC). Though these rules only apply to a publicly-held company, it would be prudent for a privately-held business to also be in compliance. The criteria developed by the SEC are noted below.

1. Identify the Contract with a Customer

A contract is an agreement between two or more parties that creates enforceable rights and obligations. The contract must be approved by all parties and clearly define each party’s rights regarding goods or services. It must also specify the payment terms. Revenue can only be recognized when it is probable that the entity will collect the consideration it is entitled to.

2. Identify the Performance Obligations in the Contract

Performance obligations are promises in a contract to transfer distinct goods or services to the customer. A good or service is distinct if it can be used on its own or with other readily available resources. Each separate performance obligation must be accounted for individually. This ensures accurate revenue recognition tied to what is actually delivered to the customer.

3. Determine the Transaction Price

The transaction price is the amount of consideration an entity expects to receive in exchange for transferring goods or services. This includes fixed amounts and may also involve variable consideration, such as discounts or incentives. Entities must estimate any variable components using either the expected value or most likely amount. Adjustments for significant financing components or non-cash consideration are also factored in.

4. Allocate the Transaction Price to the Performance Obligations

The total transaction price must be allocated to each performance obligation based on the standalone selling price of each good or service. If the standalone selling price is not directly observable, it must be estimated. Allocation ensures that revenue is matched appropriately with the value delivered. Discounts or variable consideration may be allocated to specific obligations if certain criteria are met.

5. Recognize Revenue When the Entity Satisfies a Performance Obligation

Revenue is recognized when control of the good or service transfers to the customer. This can occur over time or at a point in time, depending on the nature of the performance obligation. For obligations satisfied over time, revenue is recognized progressively using output or input methods. For point-in-time obligations, recognition occurs when the customer gains control, such as upon delivery or installation.