Revenue recognition is a critical accounting principle that determines how and when companies recognize revenue from contracts with customers. The Financial Accounting Standards Board (FASB) issued the Revenue from Contracts with Customers (Topic 606) to provide comprehensive guidance on revenue recognition across industries. This blog will walk you through the five criteria for revenue recognition outlined in Topic 606, offering a comprehensive overview of the process and its implications for financial reporting.

1. Identify the Contract with Your Customer

The first step in revenue recognition is identifying the contract with the customer. A contract with a customer has several elements, but the most overlooked may be that the contract does not have to be in writing. It can be verbal or implied through standard and customary business practices. It does need to have:

• Commercial substance
• Parties who are committed to satisfying the obligations
• Identifiable rights and payment terms
• Probable collection

2. Identify Your Performance Obligations

After establishing that a valid contract exists, you'll need to break down what you've actually promised to deliver to your customer.

Definition of Performance Obligations

Once a contract is identified, the next step is to distinguish the performance obligations within. A performance obligation is a promise to transfer a distinct good or service to the customer. A good or service is considered distinct if:

• The customer can benefit from the good or service on its own or together with other readily available resources.
• The good or service is separately identifiable in the contract.

Series of Distinct Goods or Services

In some cases, a contract may include a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. In such situations, the series of goods or services should be treated as a single performance obligation.

3. Determine Your Transaction Price

The transaction price represents the amount of consideration that an entity expects to receive from the customer in exchange for transferring goods or services. It may include fixed consideration, variable consideration, or both. When determining the transaction prices, entities need to consider:

• Variable consideration: This includes amounts subject to future adjustments, such as discounts, rebates, or performance-based incentives. These amounts must be estimated using either the expected value method or the most likely amount method.
  • Expected value method: Used when there are multiple possible outcomes, it calculates a probability-weighted average of all outcomes.
  • Most likely amount method: Used when there are only two possible outcomes, such as a bonus being paid or not paid.
• Time value of money: If the contract includes a significant financing component, the transaction price should be adjusted for the time value of money.
• Non-cash consideration: When the non-cash consideration is received, such as goods, services, or equity instruments, its fair value needs to be measured and included in the transaction price.

4. Allocation of Transaction Price to the Performance Obligations

For contracts with multiple performance obligations, the transaction price needs to be allocated. This can be based on the standalone price of each obligation or estimated by the company based on past experience. The standalone selling price can be determined using various methods, including:

• Observable prices of similar goods or services
• Adjusted market assessment
• Expected cost plus a margin
• Residual approach

5. Recognize Revenue

The final step is determining when to recognize revenue. Revenue can be recognized either over time or at a point in time, depending on the nature of the performance obligations.

• Revenue recognized over time: If a performance obligation is satisfied over time, revenue should be recognized based on the progress towards complete satisfaction of the performance obligation. The percentage of completion method or another appropriate method should be used to measure progress.
• Revenue recognized at a point in time: If a performance obligation is satisfied at a point in time, revenue should be recognized when control of the goods or services transfers to the customer. This typically occurs when legal title passes, the customer accepts delivery, or the customer has physical possession.

Special Considerations

A few topics that deserve special consideration are as follows:

• Warranties may create separate performance obligations depending on their type.
• Upfront fees such as setup, access, initiation, and membership fees are recognized over the contract unless a performance obligation is immediately satisfied.
• Sales commissions are amortized over the life of the contract.
• Gift cards are generally recognized when redeemed. However, if breakage (the portion expected not to be redeemed) can be reasonably estimated, that amount may be recognized in proportion to redemptions.
• Licenses such as software, patents, trade names, franchise names, and rights to access and use (IP addresses in particular) may be recognized over time or at the use grant date, depending on the type of license.

Financial Statement Disclosures

Entities are required to disclose relevant information about their revenue recognition policies, including the significant judgments, estimates, and changes in contract balances. Disclosures should also address the nature, timing, and uncertainty of revenue and cash flows, often through qualitative and quantitative details such as disaggregation of revenue, performance obligations, and contract assets or liabilities.

Expert Revenue Recognition Guidance with Lutz

Navigating the complexities of ASC 606 and ensuring accurate revenue recognition requires expertise and attention to detail. Lutz's experienced team understands the nuances of these standards and can help your business implement compliant revenue recognition practices with our audit and assurance services. Whether you're dealing with complex contracts, multiple performance obligations, or industry-specific challenges, our professionals provide the guidance you need to maintain accurate financial reporting. Contact us with any questions.