Revenue recognition is a fundamental accounting principle that specifies when and how a business’s income should be reported, particularly in terms of contractual obligations.
In order to drive business revenue effectively, a company’s financial statement should provide an accurate picture of the business’s performance. Understanding the modern five-step model of revenue recognition is essential for maintaining transparent profit margins.
The history of revenue recognition.
Due to software innovations and globalization, the need has increased for a consistent revenue recognition standard.
In the past, particularly before the introduction of software into business record-keeping, revenue recognition was usually tied to disclosing the cash that flowed into a company. However, as business transactions increased in complexity and scope in a global marketplace, it became apparent that it was vital to develop a consistent, all-encompassing model.
To address this priority, two bodies - the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) - released a combined standard (ASC 606 and IFRS 15) pertaining to U.S. and international businesses respectively.
Its goal was to furnish industries worldwide with a unified, comprehensive revenue recognition model. It has been in effect for public companies since 2017, and for private businesses since 2018.
The standard contains five important steps or criteria that must be understood in order to incorporate them into your integrated payment solutions and practices.
1. Identify the contract with your customer.
You must specify the exact type of agreement you have made with your customer. This includes identifying its enforceable rights and obligations.
When you and a vendor or customer come to an agreement about a sale, you have created a contract that contains rights and obligations for both sides. Should either of you fail to measure up to the standards you have set, there can be consequences.
For that reason, the first criterion of revenue recognition requires that you outline payment terms as well as the rights of both parties that pertain to the merchandise or services that are changing hands.
Whether your contract is written, verbal, or even implied, this high level of clarity and transparency from the offset ensures that all entities understand their role in the agreement both now and throughout its life cycle.
2. Identify all performance obligations.
After solidifying the contract, you must identify your performance obligations that are specified in the document.
As a provider of goods or services who has agreed upon payment with your customer, you are pledging to transfer that merchandise or service in exchange for payment.
Each performance obligation that you identify should be a good or service, or a series of goods or services, that are identical for all practical purposes and will be similarly provided to the customer.
In order for a piece of merchandise or service to be discreet and separate, the buyer must be able to benefit from it based on its own merits and attributes. Moreover, that entity needs to be individually listed and specified in the contract.
3. Set the transaction price.
Define what you expect to receive after providing the identified merchandise or services.
The majority of contracts clearly outline the exact amount of money required for providing the item or service to the buyer.
Alternatively, your contract might outline a variable consideration for non-fixed payments. If this is the case, you can estimate the amount you should receive with your best guess.
As you make your calculations, be aware of the expected timing between the transfer date of the merchandise or services, and when the customer’s payment is set to occur so that any applicable financing charges are made clear.
4. Link the transaction price to the performance obligations specified in the agreement.
Each performance obligation must be assigned a price using relative standalone selling prices.
For every performance obligation that you have specified in the contract, you must assign a transaction price. Instead of simply coming up with an arbitrary figure, use established standalone selling prices for similar items or services.
5. Recognize revenue when a payment obligation has been successfully resolved.
When the seller has done what they promised in the contract, they are entitled to payment (revenue). This can be recognized at the precise moment that the funds transfer occurred or over time.
Payment, also known as revenue, can only be transferred from buyer to seller after the seller has met their obligations as specified in the agreement.
Obtaining these funds can occur at a particular moment when the customer assumes control over the items or services. On the other hand, some funds need to be obtained over the course of days, weeks, months, or even longer.
In these cases, you will need to come up with a separate means to gauge progress for each performance obligation and update it at the end of every reporting period.
The updated AFC 606/IFRS 15 framework is designed to furnish businesses of all types throughout the world with consistent revenue recognition standards. In order to ensure that you fully adopt these standards and use them correctly in your reporting, it is recommended that you consult with an accounting professional.
North is a leading financial technology company that builds innovative, frictionless end-to-end payment solutions designed to simplify and grow businesses of all sizes. From the front door, to the back office, the developer world, and partnerships that expand the payments landscape, North offers proactive, comprehensive merchant services, in-house processing, and more.
