Revenue recognition criteria

A number of revenue recognition criteria have been developed by the Securities and Exchange Commission (SEC), which a publicly-held company must meet 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. 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:

  • Collection probability. If it is not possible to make a reasonable estimate of the amount of the allowance for doubtful accounts, then do not recognize a sale until it is possible to do so. If you are uncertain of the collection of cash from a sale transaction, defer sale recognition until payment has been received.
  • Delivery is complete. Ownership of the goods must have shifted to the buyer, as well as the risks of ownership. The buyer must also have accepted the goods. The SEC does not like bill and hold transactions, and only allows them under restricted circumstances.
  • Persuasive evidence of an arrangement. The substance of a transaction (and not just its form) should indicate that a sale transaction has indeed taken place. For example, the consignment of goods does not constitute a sale until the consignee sells the goods to a third party. The SEC specifically points out that the transfer of goods solely for demonstration purposes is not an actual sale, nor is a transfer when the "seller" is obligated to take the goods back at a specific price, or when the "buyer" has no obligation to pay for the received items.
  • The price can be determined. The buyer no longer has the contractual right to unilaterally terminate the contract and be paid back for any amounts already paid. If the price to be paid is contingent on a future event, then you must wait for that event before recognizing the sale. Also, if it is not possible to reasonably estimate the amount of any customer returns, then you must wait for more certainty regarding this item before recognizing the sale.

If any residual performance obligations related to a sale transaction are inconsequential or perfunctory, the SEC allows you to recognize a sale transaction without waiting for these items to be completed.