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Running head: REVENUE RECOGNITION
Revenue Recognition
Pryscilla Harrell
Liberty University
ACCT 301-B07 LUO
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REVENUE RECOGNITION
Revenue Recognition
Every business would benefit from using accounting principles when preparing financial
statements. There are several different ways and steps to do this. One way to use accounting
principles in preparing financial statements is the use of revenue recognition. Revenue
recognition is important to understand when preparing financial statements for a company.
Understanding what revenue recognition is and the significant times that revenue needs to be
recognized helps to make the financial statements accurate. The accuracy is increased when the
basic principles of revenue recognition and the steps on how to apply the principles to the
company’s financial statements are understood.
Revenue is known as the income that a company or business receives when it sells goods
or provides services to its customers. This income that an organization receives is usually in
cash or cash equivalents, such as accounts receivables. Revenue is important for an organization
to know because it helps to determine the net income or net loss, depending on if expenses
exceeds or is less than revenue. Revenue is an essential part of the financial statements because
it helps to show the company’s performance (Wagenhofer, 2014).
Revenue recognition includes two interrelated decisions. Not only is it important to
determine how much revenue a company receives, but it is also important to determine when to
recognize the revenue (Wagenhofer, 2014). This is where revenue recognition comes into play.
Revenue recognition is a generally accepted accounting principle (GAAP) that helps to show
what specific conditions in which revenue is recognized and how it is accounted for. Revenue
recognition principles helps to make sure that an income statement only reflects revenue that was
earned in a specific period (Spiceland, Sepe, Nelson, & Thomas, 2019). When creating an
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income statement for a specific year or period, the revenue that is shown on the income
statement should be from that year or period only.
Core Principle of Revenue Recognition
The core principle for recognizing revenue is to do so when goods or services are given
to the customers for the price that the company expects in exchange for the goods or services
(Spiceland et al., 2019). Recognizing revenue begins with an agreement between the customer
and the seller. This agreement does not have to be signed or written; it is just to show the
obligations of each party (Spiceland et al., 2019). These agreements between sellers and
customers usually contain performance obligations. Performance obligations are promises that
the seller makes when selling goods or providing services to their customers (Spiceland et al.,
2019). Sellers can recognize the revenue when a performance obligation is fulfilled. Revenue is
created when a performance obligation is satisfied (Hepp, 2018). There are five steps to use
when applying this core revenue recognition principle.
Five Steps Used When Applying Revenue Recognition Principle
The first step is to identify the agreement with the customer. This could just mean to
recognize what is being sold or provided and to who it is being sold or provided to. The
agreement produces legal and enforceable rights and obligations (Spiceland et al., 2019). A
simple agreement with only one performance obligation can be satisfied at a single point in time.
These agreements are usually easier to see because the goods or services are transferred to the
customer when the transaction occurs. Some transfers can be harder to determine, and this
makes it harder to know when revenue needs to be recognized.
The second step is to pinpoint the performance obligations that the seller is providing.
There could be more than one performance obligation that the customer expects from the seller.
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Sometimes these performance obligations could have goods and services that are distinct or are
not distinct. In order for a good or service to be treated as distinct, the goods and services can be
used on their own and separately identified from other goods and services on a contract.
Sometimes more than one performance obligation could be treated as one transaction. An
example would be materials that were purchased for a contractor to build a building. The buyer
would pay one performance obligation to the builder that would include the material and labor.
The third step for the seller to do is to define the price of the transaction. This is the price
that the seller expects the customer to pay in order to receive the goods or services the company
is providing. The transaction price of a contract can be utilized as the first measurement of the
contract, and this agreed amount should be distributed among all performance obligations
included in the contract (Colson, Bloomfield, Christensen, Jamal, Moehrle, Ohlson,…Watts,
2010). This leads to the fourth step of applying the principle of revenue recognition, and that is
to allot the price for each performance obligation if there are more than one. Each transaction
price could have a stand-alone selling price that is factored into the total selling price.
The fifth and final step is to recognize the revenue when each performance obligation is
fulfilled. Revenue can be recorded when the good or service is transferred to the customer. A
seller could use the following pointers when trying to decide if a transfer between the seller and a
customer has occurred. These pointers can include the customer has an obligation to pay the
seller, legal title to the asset, physical possession of the asset, assumed the risks and rewards of
ownership, or accepted the asset (Spiceland et al., 2019). Revenue recognition occurs when the
performance obligation is satisfied, not when cash is received. This is when revenue is
recognized at a single point in time.
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Some services are performed over a period of time, and this may make it appropriate to
recognize revenue over the period of time in which the services are performed. Revenue should
be recognized over time if the customer consumes the benefit of the seller’s work as it is
performed, the customer controls the asset as it is created, and the seller is creating an asset that
has no alternative use to the seller and the seller has the legal rights to receive payment from
progress to date (Spiceland et al., 2019). In these cases, the part of performance obligation that
has been fulfilled is the only revenue that should be recognized. Even though a seller could
recognize revenue over time, they may choose to recognize the revenue at the completion of the
performance obligation.
If a seller chooses to recognize revenue over time, they would need to know how to
determine progress toward completion. One way to do this is to use an output-based estimate of
progress toward completion. An output-based estimate of progress toward completion is
measured as the proportion of the goods or services transferred to date (Spiceland et al., 2019).
Another way to do this is to use an input-based estimate of progress toward completion. An
input-based estimate of progress toward completion uses ratio of cost incurred to date compared
to total cost estimated to complete the job (Spiceland et al., 2019).
Special Issues for Each Step
Each step can have special issues that arise for revenue recognition. These special issues
can have an effect on how revenue is recognized. Often these special issues can be ignored or not
even realized when preparing financial statements (Ismail & Kemi, 2018). These issues can help
to determine if a contract exists and if they qualify as performance obligations.
There are a few special issues with step one: identifying the agreement with the customer.
One of these special issues is that the seller believes that it is likely that they will collect all of
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the money they are entitled to receive for their goods and services provided. This could be with
a contract or without a contract as long as the seller has transferred the goods and services to the
customer. There is not a contract in place when the seller or customer has not met any
performance obligations and the contract can be terminated with no penalty to either the
customer or the seller. Sometimes there is a contract that may need to be modified.
There could be special issues when identifying the performance obligations. One way is
by utilizing prepayments. These are usually nonrefundable fees that are collected at the
beginning of a contract. Prepayments have no promise for a service or good to be delivered.
Prepayments are not considered to be performance obligations (Spiceland et al., 2019).
Warranties are another special issue for identifying performance obligations for revenue
recognition. Quality-assurance warranties assure that the performance obligation is satisfied by
making sure their product is delivered and maintained with acceptable quality. This type of
warranty is not considered a performance obligation. Extended warranties, on the other hand,
are addition performance obligations on a contract. This type of warranty protects the product or
service over and behind the quality-assurance warranty. Extended warranties are usually
purchased separately from the original good or service.
There could be special issues to determining the transaction price. Variable
considerations can be one of these issues. These types of considerations make the transaction
price based on what happens in the future. In order to show revenue recognition, the seller
should estimate the uncertain transaction amount. Another special issue with determining the
transaction price is the right of return. This is not a performance obligation because it shows that
the seller failed to satisfy the original performance obligation of providing quality goods and
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services. Sometimes the total amount of money is not given back to the customer during a right
of return. When this happens, it was become a variable consideration.
There could also be special issues when allotting the price for each performance
obligation in a contract. Stand-alone selling price can be used for goods and services that are not
normally sold separately. There are several ways to estimate stand-alone pricing. They can
include adjusted market assessment approach, expected costs plus margin approach, and residual
approach (Spiceland et al., 2019). The adjusted market assessment approach would be selling
the goods or services at a price that is considered fair in the market of conducted business.
Expected cost plus margin approach would be selling the goods and services at the price of
performance obligations plus adding a profit margin. The residual approach uses an estimate of
an uncertain stand-alone selling price.
There could also be special issues when recognizing the revenue when each performance
obligation is fulfilled. Some instances where issues may occur are when customers pay for
license. A licensing fee is paid to access a company’s intellectual property (Spiceland et al.,
2019). The revenue from these fees is recognized over a period of time if the goods and services
are expected to be affected throughout the license period. If the revenue is not affected over
time, then the revenue is recognized at the time of sale. Another issue is franchise arrangements.
In these types of arrangements, the franchisee purchases a license, but also have initial sales as
well as ongoing sales of goods and services. This would mean that the franchiser would need to
evaluate each part for its performance obligation. Another issue that may occur is bill-and-hold
arrangements. These arrangements happen when a customer purchases goods or services, but
request that shipment occur at a later date. Revenue recognition for this type of issue usually
occurs during delivery (Spiceland et al., 2019). Another issue that may occur when recognizing
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revenue is during consignment arrangements. Goods and services are sold under consignment
when they belong to one person but are being sold by another. If the goods and services are not
sold within the agreed time, the goods and services are returned to the consignor. Sales of the
goods and services to the customer is when revenue recognition occurs. The last issue that may
occur is the sale of gift cards. Sellers earn profit from gift cards when the customer spends the
value on the card. Revenue is recognized at the earliest point if revenue is earned and realizable
(Ammons, Schneider, & Sheikh, 2012).
Disclosures for Revenue Recognition
All revenue should be disclosed on financial reports. Revenue recognition requires much
disclosure. The income statement should include all revenue that is recognized. A seller should
recognize contract liabilities, contract assets, and accounts receivables on the balance sheet. A
contract liability means the seller has deferred revenue accounts because they have earned
income before fulfilling a performance obligation (Spiceland et al., 2019). An account
receivable means that the seller has fulfilled a performance obligation and has a right to receive
payment for it. A contract asset means that a seller has fulfilled a performance obligation and is
waiting for the conditions to be right to receive payment. Any of these circumstances should be
disclosed on financial statements. This helps investors understand what, where, and how
revenue is recognized.
Revenue Recognition for Long-Term Contracts
Revenue recognition for long-term contracts still follows the five-step process. However,
the identifying the performance obligation in the contract step and the recognizing revenue when
each performance obligation is fulfilled step are a little bit different. Long-term contracts can
include many products and services that can be considered separate performance obligations.
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For revenue recognition purposes, long-term contracts should be viewed as a single performance
obligation. However, revenue for long-term contracts can be recognized over time. Specialized
accounting procedures have been developed to handle the complexity of long-term contracts.
The procedures have changed and now they are based on whether a business recognizes revenue
over time or upon completion. In a normal case of revenue recognition, a seller would have a
debit to account receivables and a credit to revenue. The seller would also debit cost of goods
sold and credit their inventory. In this way the seller physically gives an asset to the customer,
recognizes it as cost of goods sold, receives cash for the goods, and recognizes revenue at that
time. The asset in the physical form and in the financial form would not be on the balance sheet
at the same time. In long-term contract revenue recognition, both the physical asset and the
financial asset may be on the balance together. This is called double counting and that should
not happen. To keep this from happening, a billings account should have an entry that offsets the
receivable so that no double counting occurs.
Conclusion
In conclusion, revenue recognition is an important part of accounting. This information
can be very useful in making decisions for the company. Revenue recognition gives the
company a better outlook of how the company is doing. It can do this by showing what the
performance obligations are and how they are being fulfilled. It also helps to determine the
stand-alone selling price for each individual good or service. Having a better understand of how
revenue recognition works can help the company thrive financially.
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References
Ammons, J. L., Schneider, G. P., & Sheikh, A. (2012). Accounting for retailer-issued gift cards:
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Colson, R. H., Bloomfield, R., Christensen, T. E., Jamal, K., Moehrle, S., Ohlson, J., . . . Watts,
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accounting standards board's joint discussion paper entitled preliminary views on revenue
recognition in contracts with customers: American accounting association's financial
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Hepp, J. (2018). ASC 606: Challenges in understanding and applying revenue
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doi:10.1016/j.jaccedu.2017.12.002
Ismail, A., & Kemi, Y. (2018). Guest editorial. Accounting Research Journal, 31(1), 2-7.
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Spiceland, J. D., Sepe, J., Nelson, M., & Thomas, W. (2019). Intermediate accounting (10th ed.).
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