Deliverable 6 - Ethical and Legal Implications

What is Revenue Recognition?

Revenue recognition is the process of recording revenue on our income statement. Although this sounds pretty straight forward, and most of the time it is, there can be some ambiguities as to the precise moment revenue should be recorded and in which accounting period.

Fortunately, we find guidance within Generally Accepted Accounting Principles (GAAP). The timing of when we recognize revenue is really a combination of two accounting principles: (1) the matching principle and (2) the revenue recognition principle. By using these two concepts, we can identify the precise period in which to record the revenue from an economic transaction.

Let’s review these concepts:

MATCHING PRINCIPLE 

The Matching principle requires us to match expenses with their related revenues in the same period. 

REVENUE RECOGNITION PRINCIPLE 

The revenue recognition principle requires us to realize (record) revenue when it is earned. 

COMPLEX REVENUE TRANSACTIONS 

The general rule is we will recognize revenue when a qualifying event has occurred, and the amount is measurable. However, as it is true with many rules, there are exceptions. There are also complex 

Revenue is the cornerstone of any business. Every business depends on sales. This is often referred to as the “top line” because it is the first line of the income statement. If the top line is not correct or accurate, then net income will not be correct or accurate.

Let’s look at the how we determine when revenue is earned. Revenue is realizable when it has been earned. This means that the goods or services have been provided AND payment is reasonably certain. In other words, the revenue generating activity is complete. In accrual accounting, the receipt of cash can be a separate transaction from the earning of revenue and payment is not a requirement for revenue to earned.

The general rule is we will recognize revenue when a qualifying event has occurred, and the amount is measurable. However, as it is true with many rules, there are exceptions. There are also complex transactions that can make the timing of the recording of revenue difficult.

Consider the situation where a company has signed a three-year contract to provide a number of services over those three years. The contract provides just a total dollar amount for all services over the three-year period. When does the revenue get recognized? At the end of the contract, after all the services are provided?

To handle difficult or complex revenue situations such as the one described above, the Financial Accounting Standards Board (FASB), along with the International Accounting Standards Board (IASB), issued the Accounting Standards Codification (ASC) 606 with provides a uniformed framework for how to recognize revenue from contracts. The previous framework was more industry specific and very fragmented.

The underlying concept in ASC 606 is that revenue is recognized when the delivery of goods or services matches the amount of consideration expected. To help with the determination, there is a five-step process to follow:

1. Identify the contract(s) with the customer

2. Identify the performance obligations

3. Determine the transaction price

4. Allocate transaction price to the performance obligations

5. Recognize revenue as each performance obligation is satisfied

While this framework is a positive step in the standardization of revenue recognition of contracts, there can still be steps in this process that can require a significant amount of judgement and detailed evaluation.

Resource(s)

Wiley GAAP 2019 : Interpretation and Application of Generally Accepted Accounting Principles