2.1 Five-step revenue recognition model
6 min read•august 21, 2024
Revenue recognition is a crucial aspect of financial reporting, ensuring accurate and consistent recording of income. The five-step model provides a structured approach for recognizing revenue from customer contracts across industries.
This model aims to improve comparability and transparency in financial statements. It covers contract identification, , transaction pricing, allocation, and , addressing various scenarios and special considerations in revenue recognition.
Overview of revenue recognition
- Provides a comprehensive framework for recognizing revenue from contracts with customers
- Applies to all entities and industries, replacing industry-specific guidance
- Aims to improve comparability and consistency in financial reporting across different businesses
Step 1: Identify contract
- Establishes the foundation for revenue recognition by defining the agreement between parties
- Requires meeting specific criteria to determine if a valid contract exists
- Impacts the timing and amount of revenue recognized in financial statements
Contract criteria
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- Approved and committed parties demonstrate agreement to rights and obligations
- Identifiable payment terms for the goods or services to be transferred
- Commercial substance exists, indicating economic consequences for the parties involved
- Probable collection of substantially all consideration entitled
- Enforceable rights and obligations for both parties are present
Combining contracts
- Occurs when multiple contracts are negotiated as a package with a single commercial objective
- Requires consideration of interdependence between contracts' pricing or performance obligations
- Results in accounting for combined contracts as a single agreement for revenue recognition purposes
Contract modifications
- Represent changes to the scope, price, or both in an existing contract
- Treated as separate contracts if they add distinct goods or services at standalone selling prices
- Accounted for prospectively or through a cumulative catch-up adjustment, depending on circumstances
Step 2: Performance obligations
- Identifies distinct promises to transfer goods or services within a contract
- Crucial for determining when and how much revenue to recognize
- Impacts the allocation of and timing of revenue recognition
Distinct goods or services
- Capable of being distinct allows customer to benefit from the good or service on its own
- Distinct within the context of the contract separates the promise from other promises
- Requires assessment of integration, modification, or interdependence with other contract elements
Series of distinct items
- Substantially the same goods or services transferred consecutively
- Each distinct item in the series meets criteria for over-time revenue recognition
- Same method used to measure progress toward completion for each distinct item
Step 3: Transaction price
- Determines the amount of consideration an entity expects to receive for transferring promised goods or services
- Excludes amounts collected on behalf of third parties (sales taxes)
- Considers various factors that may impact the final amount received by the entity
Variable consideration
- Includes discounts, rebates, refunds, credits, incentives, performance bonuses, or penalties
- Estimated using expected value or most likely amount method
- Constrained to amounts where significant revenue reversal is not probable
Significant financing component
- Adjusts for time value of money when timing of payments provides customer or entity with financing benefit
- Considers difference between promised consideration and cash selling price
- Practical expedient available for contracts with payment terms less than one year
Non-cash consideration
- Measured at fair value of the received or receivable
- If fair value cannot be reasonably estimated, measured indirectly by reference to
- Includes customer-supplied materials, equipment, or labor
Consideration payable to customer
- Includes cash amounts, credits, or other items that can be applied against amounts owed to the entity
- Accounted for as reduction of transaction price unless payment is for a distinct good or service
- Recognized at later of when related revenue is recognized or when consideration is promised
Step 4: Allocation of price
- Distributes transaction price to individual performance obligations in the contract
- Aims to reflect the amount of consideration expected for satisfying each obligation
- Crucial for contracts with multiple performance obligations or bundled goods and services
Standalone selling price
- Best evidence is observable price of good or service sold separately to similar customers
- Estimated using adjusted market assessment, expected cost plus margin, or residual approach
- Maximizes use of observable inputs and applies estimation methods consistently
Allocation methods
- Relative standalone selling price method allocates based on proportion to total contract price
- Residual approach used when standalone selling price is highly variable or uncertain
- Specified allocation required for certain
Discounts and variable consideration
- Discounts allocated proportionately to all performance obligations unless criteria for specific allocation met
- allocated entirely to one performance obligation if certain conditions satisfied
- Allocation updated for changes in transaction price or
Step 5: Satisfaction of obligations
- Determines when revenue is recognized based on transfer of control to the customer
- Distinguishes between performance obligations satisfied over time or at a
- Impacts the pattern and timing of revenue recognition in financial statements
Performance over time vs point in time
- Over time recognition if customer simultaneously receives and consumes benefits
- Point in time recognition when control transfers at a specific moment (delivery, acceptance)
- Considers indicators of control transfer such as right to payment, legal title, physical possession
Measuring progress
- Output methods based on value transferred to customer (units produced, milestones reached)
- Input methods based on entity's efforts toward satisfying the performance obligation (costs incurred, labor hours)
- Selected method applied consistently to similar performance obligations in similar circumstances
Disclosure requirements
- Enhances transparency and comparability of revenue recognition practices
- Provides users of financial statements with comprehensive information about contracts with customers
- Helps stakeholders understand the nature, amount, timing, and uncertainty of revenue and cash flows
Quantitative disclosures
- Disaggregation of revenue into categories depicting how economic factors affect revenue and cash flows
- Contract balances including receivables, contract assets, and
- Transaction price allocated to remaining performance obligations (backlog)
- Significant changes in contract asset and liability balances during the period
Qualitative disclosures
- Significant judgments and changes in judgments affecting revenue recognition
- Performance obligations including nature, timing of satisfaction, and payment terms
- Methods, inputs, and assumptions used for determining transaction price and allocating to performance obligations
- Practical expedients used and their impact on the financial statements
Special considerations
- Addresses specific scenarios that require additional guidance or modifications to the general model
- Ensures consistent treatment of complex revenue recognition situations across industries
- Provides clarity on how to apply the five-step model in unique circumstances
Contract costs
- Incremental costs of obtaining a contract capitalized if expected to be recovered
- Costs to fulfill a contract capitalized if they relate directly to a contract and generate resources for future performance
- Amortized on a systematic basis consistent with transfer of goods or services to the customer
Warranties
- Distinguishes between assurance-type (accounted for as cost accruals) and service-type warranties (separate performance obligations)
- Assurance-type warranties provide guarantee of product quality or functionality
- Service-type warranties provide additional services beyond quality assurance
Right of return
- Recognized as variable consideration in the transaction price
- Estimated using expected value or most likely amount method
- Requires recognition of refund liability and asset for right to recover products from customers
Impact on financial statements
- Alters the timing and pattern of revenue recognition for many entities
- Affects key financial metrics and ratios used by investors and analysts
- Requires significant changes to accounting processes, internal controls, and IT systems
Revenue recognition timing
- May accelerate or defer revenue recognition compared to previous standards
- Impacts industries with long-term contracts, multiple element arrangements, or variable pricing
- Potentially creates volatility in reported revenue due to estimates and judgments required
Balance sheet effects
- Introduces new balance sheet items such as contract assets and contract liabilities
- Changes in working capital due to differences in timing of revenue recognition and cash flows
- Potential impact on debt covenants and other financial metrics based on balance sheet items
Comparison with previous standards
- Highlights key differences between new revenue recognition model and previous guidance
- Helps users understand the transition impact and changes in financial reporting
- Provides context for interpreting financial statements across different accounting periods
ASC 605 vs ASC 606
- introduces a single, principles-based model for all industries
- Eliminates industry-specific guidance present in ASC 605
- Enhances disclosure requirements, providing more detailed information about revenue contracts
- Changes timing of revenue recognition for some transactions, particularly those with multiple elements or variable consideration
- Introduces new concepts such as performance obligations and standalone selling prices
Key Terms to Review (30)
Allocation methods: Allocation methods refer to the systematic ways in which a company recognizes and distributes revenues and expenses among different periods or segments of a business. These methods are essential for accurately reflecting financial performance and ensuring compliance with accounting standards. By applying appropriate allocation methods, organizations can assign revenues to specific timeframes or deliverables, aligning with the principles of revenue recognition.
Allocation of Price: Allocation of price refers to the process of distributing the total transaction price of a contract among multiple performance obligations in order to recognize revenue accurately. This concept is crucial for ensuring that revenue is recognized in a manner that reflects the economic realities of the goods or services being provided, as each obligation may have different characteristics and values.
ASC 606: ASC 606 is the accounting standard that provides a comprehensive framework for recognizing revenue from contracts with customers. It establishes a five-step revenue recognition model that aims to ensure that revenue is recognized in a manner that depicts the transfer of goods or services to customers at an amount that reflects the consideration to which an entity expects to be entitled. This standard impacts various elements of revenue recognition, including performance obligations, variable consideration, contract modifications, and more.
Collectibility Threshold: The collectibility threshold is the criterion that determines whether a company can recognize revenue from a contract based on the likelihood of collecting the payment. This concept is crucial in ensuring that revenue is recorded only when it is probable that the company will receive the consideration to which it is entitled, which helps provide a more accurate representation of financial performance.
Consideration Payable to Customer: Consideration payable to customer refers to any payment or value that a company provides to its customers as part of a sales agreement. This consideration can take various forms, such as cash, discounts, or incentives, and is often used to encourage purchases or enhance customer loyalty. Understanding this term is essential for determining how it affects revenue recognition and the overall financial statements of a company.
Construction Accounting: Construction accounting is a specialized accounting method tailored to the unique needs of the construction industry. It involves tracking costs, revenues, and profitability for individual projects, which can often span multiple years and include various phases of work. This method ensures that companies can accurately report financial performance while complying with specific regulations and accounting standards relevant to construction activities.
Contract costs: Contract costs refer to the expenses that a company incurs in the fulfillment of a contract to provide goods or services. These costs are crucial for determining the profitability of a contract and are recognized in financial statements as part of the revenue recognition process. Understanding contract costs helps businesses manage their resources effectively and comply with accounting standards that require accurate reporting of revenue and expenses associated with contracts.
Contract Liabilities: Contract liabilities are obligations that arise when a company receives payment from customers before delivering the promised goods or services. These liabilities reflect the company's responsibility to transfer goods or services to the customer in the future and are recorded as a liability until the obligations are fulfilled. They play a crucial role in the revenue recognition process, helping to ensure that companies accurately report revenue when they meet their performance obligations.
Contract modifications: Contract modifications are changes made to the terms of an existing contract, which can impact the revenue recognition process, performance obligations, and related costs. When a contract is modified, it’s essential to assess whether the modification creates new performance obligations or alters existing ones, as this directly influences how and when revenue is recognized. Understanding these adjustments is crucial for determining the accurate financial reporting of revenue and costs associated with the modified contract.
Cost-plus contract: A cost-plus contract is an agreement where a contractor is reimbursed for all allowable expenses incurred during the project, plus an additional fee, which is often a percentage of the costs. This type of contract allows for flexibility in budgeting and project scope, as the contractor is assured they will be compensated for their costs, making it especially useful for projects with uncertain timelines or costs.
Discounts and Variable Consideration: Discounts and variable consideration refer to adjustments in the transaction price of a contract due to factors like sales discounts, rebates, or refunds. These adjustments are crucial in determining the amount of revenue that can be recognized in financial statements, as they impact the overall transaction price and ultimately the timing and amount of revenue recognition under the revenue recognition model.
Fixed-price contract: A fixed-price contract is a type of agreement where the payment amount does not change regardless of the actual costs incurred by the contractor. This means that the contractor agrees to deliver a specified service or product for a set price, providing budget certainty for the buyer while also placing the risk of cost overruns on the contractor. These contracts are often used in project-based work, where defining clear deliverables and timelines is essential to both parties.
Identify Contract: To identify a contract means to recognize and establish an agreement between parties that creates enforceable rights and obligations. This step is crucial in the revenue recognition process, as it determines the existence of a legally binding arrangement that outlines the goods or services to be delivered, as well as the payment terms involved.
IFRS 15: IFRS 15 is the International Financial Reporting Standard that outlines the principles for recognizing revenue from contracts with customers. It establishes a comprehensive framework for determining when and how much revenue to recognize, emphasizing the transfer of control over goods or services to customers as the key factor in revenue recognition.
Measuring Progress: Measuring progress refers to the evaluation of how much work has been completed toward fulfilling a contract or achieving a milestone in revenue recognition. This concept is crucial for determining when revenue can be recognized, especially in long-term contracts where performance is delivered over time rather than at a single point. The method of measuring progress helps businesses accurately reflect their financial performance and ensures that revenue is recognized in a way that matches the delivery of goods or services.
Non-cash consideration: Non-cash consideration refers to any form of payment received for goods or services that does not involve cash. This could include items such as stocks, bonds, real estate, or other assets. Understanding how non-cash consideration impacts revenue recognition is crucial because it requires assessing the fair value of the consideration received, which can affect the timing and amount of revenue recognized in financial statements.
Performance Obligation Satisfaction: Performance obligation satisfaction refers to the completion of a promise made in a contract to transfer goods or services to a customer. This concept is key in revenue recognition, indicating that revenue can only be recognized when the performance obligations are fulfilled, ensuring that financial statements accurately reflect a company's economic activity and obligations.
Performance Obligations: Performance obligations are promises in a contract to transfer distinct goods or services to a customer. They form the core of the revenue recognition process, determining when and how revenue is recognized based on the completion of these obligations. The identification and fulfillment of performance obligations directly influence financial reporting and the timing of revenue recognition, ensuring that income is recorded in a way that reflects the actual delivery of products or services to customers.
Performance over time: Performance over time refers to the assessment of a company's financial results and operational efficiency across multiple reporting periods. This concept emphasizes the importance of understanding trends, patterns, and changes in a company's financial performance to make informed decisions. It is crucial for evaluating revenue recognition, as it reflects how well a company sustains its business operations and delivers value to customers consistently.
Point in Time: A point in time refers to a specific moment when a company recognizes its financial transactions or events, usually at the end of an accounting period. This concept is essential for understanding how revenues and expenses are reported, impacting the financial statements. Recognizing events at a point in time helps in providing a clear snapshot of a company’s financial position at that specific moment, allowing stakeholders to assess performance accurately.
Revenue Disclosures: Revenue disclosures refer to the detailed information that companies provide about their revenue recognition practices, including how and when revenue is recognized in financial statements. This transparency is essential as it helps stakeholders understand the financial performance and position of a business, ensuring that revenue figures accurately reflect the company's operations according to the five-step revenue recognition model.
Right of Return: The right of return refers to the legal right of customers to return goods to the seller for a refund, exchange, or repair. This concept is essential in revenue recognition because it can impact how a company recognizes revenue from sales when there is uncertainty about whether the customer will keep the purchased goods.
Satisfaction of obligations: Satisfaction of obligations refers to the fulfillment of contractual duties as specified in an agreement, often leading to the recognition of revenue when these obligations are met. This concept is crucial in determining when a company can report revenue on its financial statements, ensuring that earnings are reported accurately and at the appropriate time. It establishes a connection between the completion of a task or delivery of goods and the economic benefits that arise from that transaction.
Segment reporting: Segment reporting is the practice of breaking down a company's financial information into different segments or components, typically based on business lines or geographical areas, to provide stakeholders with clearer insights into its financial performance. This reporting is essential for understanding how various parts of a business contribute to its overall results, particularly in the context of revenue recognition, interim reporting, and changes in the reporting entity.
Significant Financing Component: A significant financing component refers to the time value of money that is considered when recognizing revenue for transactions where the payment is made significantly after or before the transfer of goods or services. This concept highlights that when a contract has a significant financing component, revenue should reflect the cash selling price adjusted for the time value of money, ensuring that the financial statements accurately portray the economic reality of the transaction.
Software revenue recognition: Software revenue recognition refers to the process of recognizing revenue from software sales and services in accordance with accounting standards. This concept is crucial for companies that develop or sell software, as it ensures that revenue is reported accurately based on the delivery of software products or services and the fulfillment of contractual obligations.
Standalone Selling Price: The standalone selling price is the price at which a company would sell a good or service separately to a customer, without any discounts or bundling. This concept is crucial when determining how to allocate revenue to multiple performance obligations in contracts under the revenue recognition model, ensuring that each element's value is accurately represented in financial reporting.
Transaction price: Transaction price is the amount of consideration that an entity expects to receive in exchange for transferring goods or services to a customer. This concept is crucial as it forms the basis for revenue recognition, influencing how companies measure performance and the timing of revenue reported in financial statements. Understanding transaction price helps clarify agreements between parties and how various factors, such as discounts or variable considerations, impact the final amount recognized as revenue.
Variable consideration: Variable consideration refers to the portion of a transaction price that can change based on the outcome of future events. This concept is crucial in recognizing revenue accurately, as it helps businesses account for discounts, incentives, or other uncertainties that might affect the amount they expect to receive. It is key in ensuring that the revenue reported reflects the true economic reality of transactions, impacting how agreements are understood and executed.
Warranties: Warranties are promises made by a seller regarding the condition of a product and the responsibilities they will take if the product fails to meet those conditions. These guarantees are significant as they impact the seller's revenue recognition, especially under the five-step model, by potentially creating additional obligations that must be considered when determining the timing and amount of revenue to be recognized.