The 5 Step Approach To Revenue Recognition

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The Financial Accounting Standards Board (FASB) issued Revenue from Contracts with Customers (Topic 606) to clarify and apply revenue recognition principles consistently across industries. The guidance establishes a framework that outlines how financial statement users should report the nature, amount, and timing of revenue from contracts with customers.

The standard will go into effect for nonpublic entities with fiscal years beginning after Dec. 15, 2018. Early adoption is allowed.

What is revenue recognition?

Revenue recognition shows the transfer of promised goods or services in an amount that reflects how a business expects to be compensated. In order to comply with Topic 606, every business must follow these five steps:

 

Step 1: Identify the contract with the customer

 

The contract can be written, verbal, or implied and is based on your business’ ordinary practices. The contract should outline payment terms and any other rights of your business and the customer related to the goods or services that will be transferred.

 

Step 2: Identify the performance obligations in the contract

 

Once the contract is established, identify each promise you make to the customer – also known as the performance obligation. A performance obligation is a distinct good or service, or a series of distinct goods or services, that are substantially the same and have the same pattern of transfer to the customer.

 

Step 3: Determine the transaction price

 

Fixed consideration, variable consideration, or both types may be included in the contract. If variable consideration is included, estimate the amount of variable consideration you are entitled to. You can use the expected value method or most likely amount method to calculate this amount.

Pay attention to the timing of the payment and how much time will pass between the transfer of promised goods and services and when the customer pays to determine if there is a financing component. If a significant amount of time passes, adjust the transaction price for the time value of money.

 

Step 4: Allocate the transaction price to the performance obligations in the contract

 

Assign a price to each performance obligation in the contract. Base the prices on relative standalone selling prices like the sale of similar goods or services, a contractually stated price, or a list price.

If you can’t directly observe a standalone selling price, you can estimate the price using one of these methods: adjusted market assessment, expected cost plus margin, or residual.

 

Step 5: Recognize revenue when, or as, the entity satisfies a performance obligation

 

You will either recognize revenue over time or at a point in time. If recognizing revenue over time, apply a single method of measuring progress for each performance obligation. Apply this method to any similar performance obligations and remeasure the progress at the end of each reporting period.

You can recognize revenue at a point in time, if the performance obligation doesn’t meet the criteria to recognize revenue over time. The performance obligation is met at the most practical point in time when the customer gains control of the asset.

 

Though the guidance seeks to simplify the process of recognizing revenue, a thorough understanding of the new standard is key for successful adoption and reporting. The five steps outlined above provide a general overview and description of each step.

Consult with an accounting professional to ensure you understand the requirements, responsibilities, and details of each step.

 

Have questions about revenue recognition? Let’s talk!


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