5 steps to revenue recognition

Wipfli Insights Team

Nov 17, 2020

22 min read

The accounting industry identified the need to form a single, unified, global revenue recognition strategy — announcing the final standard for global revenue recognition in May 2014 — with the standard taking effect in 2018 for public company financial statements and in 2019 for private entities. For many businesses, this change will be the largest and most complex accounting project they’ve ever undertaken.

What is the new revenue recognition standard?

In general terms, the new standard moves away from the rules-based approach provided in U.S. Generally Accepted Accounting Principles (GAAP) and toward a more principles-based method. It eliminates industry-specific guidance, which provides fairly straightforward methods of recognizing revenue. Instead, it offers very broad guidelines that require numerous and significant judgments to recognize revenue across most industries. Rather than determining which GAAP standard to apply to a transaction, management must now determine how to apply this single standard to all transactions.

Different industries will see varying levels of impact from the implementation. In addition, some scenarios will draw more impact than others. For example, complex and variable contracts will be more complicated to record, as will contracts with multiple revenue streams and contracts that contain customer acceptance provisions, sales commissions or warranties.

Here’s what you need to know about the massive change ahead.

The 5 steps of revenue recognition

The initial Accounting Standards Update 2014-09 included 156 pages and many subsequent clarifications. Although there are numerous considerations for each contract, the starting point is clear. The standard has five distinct steps to recognize revenue:

Identify each contract your company has with a customer.
Identify performance obligations in the contract.
Determine the transaction price for the contract.
Allocate the transaction price for each specific performance obligation.
Recognize revenue when each performance obligation is satisfied.

Each customer contract must be evaluated separately in the context of the new standard and the five steps, without regard to how revenue was recognized in the past. Each step has many potential judgment calls and variables to be considered, hence the heavy time and resource commitments to adopt the new standard.

Revenue recognition, step by step

If your company has not already developed an implementation plan, it is highly recommended that you commit to a plan early this year. For private companies, a good timeline would be as follows:

Contract and system analysis: Assign a team to understand the standard and to lead the implementation if this has not already been done. Educate team members and others internally. Make a tracking spreadsheet of all contracts and terms. Identify the current processes for initiating, storing and accounting for contract data. Determine whether you will use a retrospective or cumulative effect transition method. Utilize the new standard by applying the five steps to individual contracts. Determine the differences from current GAAP and review the impacts. Document judgments made for each contract. Consider the need to change any processes, including IT systems and internal controls.
Beginning implementation: Consider running parallel revenue recognition systems. Determine the full financial impact the standard will have, taking into consideration things such as key performance indicators, debt covenants and compensation agreements. Communicate with key stakeholders, such as bankers, investors, governing boards and any others who may be impacted by the change in revenue recognition.
Mandatory implementation: Implement the transition method selected to the contracts. Implement any changes needed to IT systems, processes and controls. Continue to keep an open line of communication with key stakeholders during implementation.

Step 1: Identify contracts with customers

The first step — identifying contracts with customers — may sound easy. Most companies know when they have a contract in place, right?

Unfortunately, Accounting Standard Codification (ASC) 606 has nuances that make it complicated. This new standard defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations” and states that enforceability is “a matter of law.”

Five elements must be present to constitute a contract under ASC 606:

All parties to the contract must approve the contract (in writing, orally or in accordance with other customary business practices) and be committed to performing their respective obligations.
You should be able to identify each party’s rights regarding goods or services to be transferred.
You should be able to identify payment terms for goods or services to be transferred. ASC 606 allows for variable consideration. This is a substantial change from current GAAP, which require fixed and determinable payment terms.
The contract must have commercial substance (i.e., risk, timing, or future cash flows are expected to change as a result of the contract).
Collection should be probable. The amount that’s collected does not have to be the contractually stated amount — but it should be probable that you’ll collect a substantial amount of what’s due for any goods or services you transfer to a customer. Recognizing whether a contract exists requires some evaluation of the customer and whether collection is likely to occur. The evaluation only needs to consider the customer’s ability and intention to pay or, in other words, credit risk. (Other factors related to performance and measurement are considered in subsequent steps.)

The process of establishing the existence of contracts with customers will vary across legal jurisdictions, industries and entities.

Right to cancel

Importantly, a contract does not exist if either party to the contract has a unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party. The new standard defines a “wholly unperformed contract” as one in which:

You have not transferred any promised goods or services to the customer or
You have not received (and are not yet entitled to receive) any consideration for promised goods or services.

Subsequent accounting for a contract

Once a contract has been identified, there is no requirement to reassess its existence unless there is a significant change in circumstances. One of the examples given in the standard refers to substantial deterioration in a customer’s ability to pay for goods or services after a contract begins. In this instance, you may reassess whether you’ll be able to collect the consideration you’re entitled. If the customer’s ability to pay for future obligations is not probable, then the criteria for a contract are not met.

Clearly, an assessment like this involves significant judgment. The concept of bad debt expense and credit losses still exists and will be recognized as an expense on the income statement, as it is today. However, you will have to consider if credit deterioration of a customer relates to performance obligations that were already satisfied (bad debt) or performance obligations of the future, which may impact the existence of a contract.

When the criteria above are not met, or are no longer met, a contract liability is measured and recorded at the amount of consideration received from the customer until revenue can be recognized. The standard allows revenue recognition in these circumstances when one of the following occurs:

You have no remaining obligations to transfer goods or services to the customer and substantially all the consideration promised has been received and is nonrefundable.
The contract has been terminated and the consideration received is nonrefundable.
You have transferred control of the goods or services to which the consideration received relates, and there is no obligation under the contract to transfer additional goods or services, and the consideration received is nonrefundable.

Combining contracts

Two or more contracts entered into at or near the same time, with the same customer, can be accounted for as a single contract if one or more of the following conditions are met:

The contracts are negotiated as a package with a single commercial objective.
The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
The goods or services promised in the contracts are a single performance obligation.

Contract modifications

A contract modification is a change in the scope or price (or both) of a contract that is approved by all parties. In some industries and jurisdictions, a contract modification may be described as a change order, a variation or an amendment.

Under the new standard, a contract modification could qualify for several different accounting treatments depending on the circumstances. It may be treated as:

A separate contract.
The termination of an existing contract (followed by the creation of a new contract).
Part of the existing contract.

Important reminders for Step 1 of revenue recognition

Review every contract you have with customers, possibly engaging legal counsel to help ensure contracts create legally enforceable rights and obligations. Also, review each entity’s credit policies to make sure collectibility is probable.

Step 2: Identify performance obligations

Step two impacts how much revenue will be recognized and when a company can record revenue.

ASU 606 defines a performance obligation as “a promise to provide a good or service to a customer.” The promise can be explicitly stated, implicit or assumed based on customary business practices. Understanding all the promises in a contract is a challenging part of this new guidance.

The contract definition is very broad, and it’s not limited to goods or services that are clearly described in the contract. The definition encompasses promises implied by other means, such as customary business practices, published policies and statements made through email or other communication. If any of those promises lead to an expectation that a good or service will be delivered to the customer, under the new guidelines, it must be honored.

In order to allocate the transaction price to performance obligations, the good or service has to be:

A distinct good or service or bundle of goods or services or
A series of distinct goods or services that are materially the same and have the same pattern of transfer to the customer.

The FASB describes a distinct good or service as one that generates an economic benefit to the customer on its own or together with other readily available resources. A readily available resource would be a good or service that is sold separately or a resource that the customer already has. A good measure of whether a good or service is distinct is to determine if it can be sold on a standalone basis.

Often, there are multiple performance obligations in a contract. These are accounted for on a standalone basis if they are separately identifiable or distinct from other promises in the contract.

A series of distinct goods or services that have the same pattern of transfer can be considered a performance obligation satisfied over time. The same method is used to measure progress toward completion for each distinct good or service in the series.

Performance obligations are satisfied and revenue can be recognized when a customer obtains control of the asset or benefits from the services provided. Those may occur at a point in time or over a period of time, depending on certain facts.

At a point in time: The performance obligation is satisfied, and revenue is recognized when control of the good or service is transferred to the customer.

Over a period of time: The performance obligation is satisfied and revenue is recognized over time if any of the following conditions are met:

The customer receives and consumes the benefits of the goods or services as they are provided by the entity (e.g., routine or recurring services like cleaning are an example of a series of services that are substantially the same and have the same pattern of transfer).
The goods or services create or enhance an asset the customer controls as that asset is created or enhanced (e.g., this would be common for contractors who renovate a home owned by the customer or build a structure on land owned by the customer).
The asset created does not have an alternative use to the customer and the customer has an enforceable right to payment for performance completed to date (e.g., custom design services or construction of a custom product to customer specifications). An enforceable right to payment for performance completed to date should include the right to costs incurred to date and a reasonable profit margin.

When a performance obligation and revenue are recognized over time, it is similar to the “percentage of completion.” The primary difference is that revenue is intended to be recognized in a pattern that represents the transfer of control to the customer.

The standard provides two acceptable methods of measuring progress:

Output method: Revenue is recognized based on the value transferred to the customer relative to the remaining value to be transferred. Some examples would be surveys of performance completed to date, appraisals of results, milestones reached, time elapsed or units produced.
Input method: Revenue is recognized based on the company’s effort to satisfy the performance obligation, relative to the total expected effort to satisfy the performance obligation. Some examples are resources consumed, labor hours expended, costs incurred, time elapsed and machine hours used. The input method has to carefully consider whether the inputs truly measure progress to completion. For example, materials may be purchased and recorded as inputs to the project, but due to uninstalled materials or inefficiencies resulting in wasted material, the full amount may not properly depict progress.

Step 3: Determine the transaction price

ASU 606 defines transaction price as “the amount of consideration the entity expects to be entitled to, in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties” (e.g., sales tax).

In some revenue transactions, the transaction price is clear. For example, a customer walks into a store and buys a new coat for $200. The customer pays the store and leaves with the coat. The transaction is complete and the store records $200 of revenue.

Under the new revenue recognition standard, however, this straightforward transaction could become complicated if, for instance, the customer can return the coat for a full refund. Complexities like variable consideration, rights of return and other terms inherent in some contracts can make determining the transaction price tricky.

Variable consideration

Variable consideration is an amount that’s dependent on the occurrence or non-occurrence of a future event. Variable consideration includes discounts, rebates, refunds, price concessions, incentives, performance bonuses, penalties, rights of return and other price modifications.

Variability can be explicitly stated in a contract or it can be implied through customer business, industry practices or other means. ASC 606 requires you to estimate the impact of the expected variability in the transaction price and allocate it to the performance obligations, so it is recognized as revenue. This differs from current U.S. GAAP, which would not have a company record variable consideration until the contingency was resolved.

In the new standard, variable consideration can be estimated two ways:

The expected value method (i.e., the sum of the probability-weighted amounts in a range of possible outcomes).
“The most likely amount method,” which is the most likely outcome of the contract. This method is best suited when there are only two possible outcomes (e.g., a company finishes ahead of schedule and receives a performance bonus, or it does not).

These two methods are not intended to be policy choices. A company is supposed to pick the best estimate of the variable consideration based on the facts and circumstances. In general, the concept of variable consideration applies to contracts where revenue will be recognized over time rather than at a point in time.

Constraining estimates of variable consideration

The transaction price should include an estimate of variable consideration only if it is unlikely that there will be a significant reversal of the revenue recognized when the uncertainty is resolved.

How do you assess whether there will be a significant reversal in revenue recognized? Consider both the likelihood and the magnitude of the revenue reversal. For example:

Is the amount of consideration highly impacted by factors outside the company’s influence (e.g., volatility in a market, the judgment or actions of third parties, weather conditions, or a high risk of obsolescence of the promised good or service)?
How long will it take to determine the amount of consideration?
Do you have experience with similar types of contracts and a reasonable ability to predict the likelihood of reversal?
Do you typically offer a broad range of price concessions? Have you changed the payment terms and conditions of similar contracts in similar circumstances?
Does the contract have a large number and broad range of possible consideration amounts?

Refund liabilities

Under the new standard, revenue should be offset by a refund liability if the company expects refunds will occur. The amount of the refund liability should be estimated, and the estimate should be adjusted each reporting period.

When a right of return exists, in addition to the right to a refund, an asset is recognized with an offset to cost of goods sold for the value of the expected returned goods. This means the entry to record revenue would look something like this:

Refund Liability: Right of Return:

Accounts receivable: 100 Right of return asset: 5

Revenue: 80 Cost of goods sold: 5

Refund liability: 20

Estimates of the refund liability and right of return asset should be updated at the end of each period, resulting in an increase or decrease in revenue recognized. A right of return asset is measured at the original inventory carrying amount, less the expected cost to recover the asset, less any anticipated decrease in the value of the asset.

Significant financing components

ASC 606 requires you to adjust the transaction price for the time value of money, even if the contract does not explicitly call for a financing component. When the period of time between delivery to the customer and the customer payment is less than a year, there is a practical expedient that can be used to eliminate consideration of the time value of money. For all other long-term contracts, you must consider if there is a financing component. (If customer payments are deferred, the entity recognizes interest income; if payments are accelerated, the entity recognizes interest expense.)

How do you determine whether a financing component is significant? Assess contracts for:

Any difference between the amount of promised consideration and the true cash selling price of the promised goods or services and
The combined effect of (a) the expected length of time between the transfer of promised goods or services to the customer and when the customer pays for goods or services; and (b) the prevailing interest rates in the relevant market.

According to the standard, the following situations would not indicate a financing component:

The customer paid for goods or services in advance and the timing of the transfer of those goods or services is at the discretion of the customer.
A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies based on the occurrence or nonoccurrence of a future event that is not substantially within either entity’s control (e.g., if the consideration is a sales-based royalty).
The difference between the promised consideration and the cash selling price of the good or service arises for reasons other than the provision of finance, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide protection from either party failing to adequately complete some or all of its obligations under the contract.

The interest income or interest expense should be presented separately from revenue from contracts with customers in the income statement. Interest income or interest expense is recognized only to the extent that a contract asset (or receivable) or a contract liability is recognized in accounting for a contract with a customer.

Noncash consideration

Some contracts may include arrangements in which a customer promised consideration in a form other than cash. The estimated fair value of the noncash consideration at the beginning of the contract should be included in the transaction price. Any variation in the fair value of noncash consideration after the initial measurement at contract inception does not affect the transaction price.

Consideration payable to a customer

Consideration payable to a customer includes cash amounts paid, or expected to be paid, to the customer as well as things like credits, coupons or vouchers that can be applied against what is owed. Consideration payable to a customer reduces the transaction price and therefore it also reduces the revenue recognized in a transaction, unless the consideration is in exchange for a distinct good or service and does not exceed the fair value of that good or service.

Historically, none of these considerations were required to determine the amount of revenue recognized. Depending on the facts and circumstances, variable consideration may result in the acceleration of revenue recognition. In addition to the facts, the transaction price is subject to significant judgment calls by management. Make sure processes and controls are strong to support consistent and reliable revenue reporting.

Step 4: Allocate the transaction price

After the transaction price is set, companies need to allocate it to specific performance obligations in the contract based on the relative, standalone selling price. Per the standard, the standalone selling price is “the price an entity would sell the good or service for if they sold it separately to a customer.”

If you have standalone sales of a similar good or service, then the transaction price is evident. If an easily observable selling price is not available, you will have to estimate one using observable inputs, such as market conditions, company-specific factors and customer information. The method you use to estimate standalone selling price should be applied consistently in like circumstances.

ASC 606 includes specific suitable methods for estimating the standalone selling price of goods and services, including the:

Adjusted market assessment approach: Evaluate the market and estimate what a customer would be willing to pay for goods or services. You can use prices from competitors and adjust them to reflect your company’s costs and margins.
Expected cost plus a margin approach: Estimate the expected costs to satisfy a performance obligation and then add an appropriate margin for the good or service.
Residual approach: Estimate the standalone selling price. Take the total transaction price, less the sum of observable standalone selling prices of other goods or services in the contract. This method can only be used if there is a broad range of current selling prices to other customers and no single representative selling price, or the good or service has not previously been sold and there is no established price for the good or service.

It is possible to use a combination of methods.

Allocation of a discount

What if a customer receives a discount for purchasing a bundle of goods or services? When this occurs, the sum of the standalone selling prices may exceed the promised consideration in a contract (i.e., the bundle is sold at a discount).

Because the total transaction price is allocated based on relative standalone selling prices, the discounted price causes complexity when the discount is allocated to one or more specific performance obligations, but not all. A discount should be allocated entirely to certain performance obligations, but not all, if:

You regularly sell each distinct good or service on a standalone basis or
You regularly sell a bundle of some of those distinct goods or services at a discount relative to their standalone selling prices. The discount attributable to each bundle should be substantially the same as the discount in the contract. In addition, the performance obligations to which the entire discount belongs should be readily observable.

If there is a discount allocated to some but not all performance obligations in the contract, the allocation should be made before using the residual approach to estimate any standalone selling prices.

Allocation of variable consideration

Variable consideration in a contract may be related to the entire contract or a specific part of the contract. The variable amount of the consideration should be allocated entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation if both these criteria are met:

The terms of the variable payment relate directly to a performance obligation.
Allocating the variable consideration entirely to a single performance obligation meets the overall goal to allocate the transaction price in an amount the entity expects to receive for that individual good or service. In other words, the variable consideration can be allocated entirely to a performance obligation if it doesn’t result in allocating more or less revenue than should be allocated based on standalone selling prices.

Subsequent changes in selling prices should be allocated to the contract in a way that is consistent with the original allocation of the transaction price, except in some unique circumstances where changes relate only to one specific performance obligation or there is a contract modification.

Observable evidence is a key consideration in step 4 of ASC 606. Carefully document how you determine standalone selling prices, allocating discounts and variability.

Step 5: Recognizing the revenue

Finally, it’s time to recognize revenue.

Revenue recognition happens as each performance obligation is met by transferring a promised good or service to a customer. The transfer is complete when a customer obtains control of an asset or a service.

Like many of the other steps, there are judgments to be made. One critical judgment is whether the performance obligation is satisfied at a point in time or over time. Each performance obligation in a contract must be evaluated individually.

Another important judgment is determining when a customer obtains control of the good or service (which renders the performance obligation satisfied). The standard defines control as “the ability to direct the use of and obtain substantially all of the remaining benefits from the good or service in a reasonable way.” Some examples include:

Using the asset to produce goods or provide services
Consuming it to improve an asset or decrease costs
Selling or exchanging the asset for other valuable goods, services, or rights
Transferring the asset to settle a liability
Licensing or leasing the asset to others
Pledging the asset as a security interest
Holding the asset so that others cannot use it

Note that determining control in the revenue recognition standard is not always the same as the concept of control in other accounting standards, such as ASC Topic 810 – Consolidation, or ASC Topic 860 – Transfers of Financial Assets. It is important to understand control specifically in the context of ASC Topic 606 – Revenue from Contracts with Customers.

Again, performance obligations can be satisfied, and revenue recognized, over time or at a point in time.

When recognizing revenue over time, the objective is to do so in a pattern commensurate with the transfer of control to the customer. The standard allows the use of output or input models to measure progress towards completion.

Under the new standard, recognizing revenue over time is not a policy choice as the percentage of completion was prior to ASC 606. If the criteria for recognizing revenue are not met, then revenue is recognized at the point in time that control passes to the customer.

How Wipfli can help

The new standard for revenue recognition is a major overhaul for most accounting teams. Start developing an implementation plan now and build a team that can support your transition. Our tax and revenue recognition professionals understand the ins and outs of the new standard and can help you identify all the processes, technology updates and training you need to tackle — as well as the impact to your accounts. Contact us today to learn more.