Revenue recognition is the conditions under which an organization can recognize a sale transaction as revenue. The intent of revenue recognition is to do so in a manner that reasonably depicts the transfer of goods or services to customers, for which consideration is paid that reflects the amount to which the seller expects to be entitled. The following is a five-step process to determine whether revenue can be recognized:
- Link the contract with a specific customer. There is usually a written contract that defines a financial payment, though it is not necessary to have a written contract; an oral arrangement can be used as the basis for revenue recognition.
- Note the performance obligations required by the contract. A performance obligation is essentially the unit of account for the goods or services contractually promised to a customer. The performance obligations in the contract must be clearly identified. This is important in recognizing revenue, since revenue is considered to be recognizable when goods or services are transferred to the customer.
- Determine the price of the underlying transaction. This step involves the determination of the transaction price built into the contract. The transaction price is the amount of consideration to be paid by the customer in exchange for its receipt of goods or services. The transaction price does not include any amounts collected on behalf of third parties.
- Match this price to the performance obligations through an allocation process. The basic rule is to allocate that price to a performance obligation that best reflects that amount of consideration to which the seller expects to be entitled when it satisfies each performance obligation. To determine this allocation, it is first necessary to estimate the standalone selling price of those distinct goods or services as of the inception date of the contract. If it is not possible to derive a standalone selling price, the seller must estimate it.
- Recognize revenue as the various obligations are fulfilled. Revenue is to be recognized as goods or services are transferred to the customer. This transference is considered to occur when the customer gains control over the good or service.