ASC 606 and IFRS 15: Five steps of revenue recognition

Revenue recognition

Revenue recognition is the accounting process through which an entity records revenue in its financial statements. The entity determines the appropriate timing and amount of revenue to be recognized based on the fulfillment of specific criteria outlined in accounting standards such as ASC 606 and IFRS 15.

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Entity

In both ASC 606 and IFRS 15, the term entity is used to refer broadly to the business or organization that is entering into contracts with customers and recognizing revenue. The term encompasses various types of organizations, including corporations, partnerships, and other forms of business structures, as well as not-for-profit organizations, cooperatives, and governmental entities.

Under these standards, revenue is recognized when control of goods or services has been transferred to the customer. This recognition occurs when the performance obligations specified in a contract are satisfied, not necessarily when payment is received.

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Performance obligation

A performance obligation is a promise in a contract to transfer a distinct good or service to a customer. Under both ASC 606 and IFRS 15, a performance obligation is identified when the good or service is distinct, meaning it is capable of being sold separately or is distinct within the context of the contract.

Why revenue recognition matters

Accurate financial reporting

Revenue recognition ensures that an entity's financial statements accurately reflect its performance during a specific period. For instance, if an entity delivers a good in December but receives payment in January, it must recognize the revenue in December when the good is delivered. This helps create an accurate financial picture, allowing decision-makers to track performance.

Compliance with accounting standards

Different countries and industries follow specific guidelines for revenue recognition, such as ASC 606 (U.S. GAAP) or IFRS 15 (international standards). These standards are designed to standardize revenue reporting, ensuring consistency and comparability across companies and industries. By adhering to these standards, companies can meet compliance requirements and avoid potential legal or financial issues.

Building trust with stakeholders

Accurate and transparent revenue recognition practices build trust among investors, lenders, regulators, and other stakeholders. By following proper accounting standards, companies show that they are committed to financial integrity and transparency, which can attract investors and enhance credibility.

Revenue is a better metric for performance

In conclusion, while income provides a complete picture of profitability after all expenses, revenue is a clearer and more direct indicator of business performance, making it the preferred metric for evaluating how well an entity is doing in its core operations.

Examples of revenue recognition

Example 1: Selling a good

When an entity sells a good, revenue is recognized when the good is delivered to the customer. For instance, if an entity sells a television to a customer, revenue is recognized when the television is delivered and control is transferred, even if the customer pays later.

Example 2: Providing a service

For services that are provided over time, such as consulting or subscription services, revenue is recognized gradually as the service is rendered. For example, if an entity signs a one-year consulting contract, it will recognize revenue on a monthly basis as the services are provided.

Example 3: Long-term contracts

For long-term projects like construction, revenue recognition may occur over time. As work is completed, revenue is recognized based on progress. For example, in a construction contract, the entity would recognize revenue over time as the building is constructed, with the final recognition occurring when the building is completed.

The five steps of ASC 606 and IFRS 15

Both ASC 606 and IFRS 15 provide a comprehensive framework for revenue recognition. They share a common five-step model for recognizing revenue from contracts with customers. These steps are designed to ensure consistency, transparency, and comparability in revenue reporting across entities and industries.

stateDiagram-v2
    [*] --> Step1_Identify_Contract
            Step1_Identify_Contract: Step 1 - Identify the contract
    
    Step1_Identify_Contract --> Step2_Define_POs : Contract Signed
    Step2_Define_POs: Step 2 - Define performance obligations (POs)
    
    Step2_Define_POs --> Step3_Determine_Transaction_Price: POs identified
    Step3_Determine_Transaction_Price: Step 3 - Determine the transaction price

    Step3_Determine_Transaction_Price --> Step4_Allocate_Price: Transaction price determined
    Step4_Allocate_Price: Step 4 - Allocate transaction price to the POs
    
    Step5_Recognize_Revenue: Step 5 - Recognize revenue

    state Step2_Define_POs {
        PO1_Step2: PO 1
        PO2_Step2: PO 2
    }

    state Step4_Allocate_Price {
        PO1_Step4 --> PO1_Completed : Fulfilled at a point in time
        PO1_Step4: PO 1
        PO2_Step4 --> PO2_Completed : Fulfilled over time
        PO2_Step4: PO 2
    }

    state Step5_Recognize_Revenue {
        PO1_Completed --> Contract_Completed : Revenue recognized PO 1
        PO1_Completed: Recognize revenue for PO 1
        PO2_Completed: Recognize revenue for PO 2
        PO2_Completed --> Contract_Completed : Revenue recognized PO 2
        Contract_Completed --> [*] : Revenue recognized for contract
        Contract_Completed: Contract closed
    }

note left of Step2_Define_POs
        **Performance Obligations (POs)** are typically **not explicitly part of the initial contract**. They are **identified after the contract is signed**, based on the agreed terms. POs are **documented internally** by the entity, often in revenue recognition systems or project management tools, where the specific promises or deliverables are tracked for proper revenue recognition.
    end note

note right of Step2_Define_POs
        In this example, we define two POs: one that will be fulfilled at a **point in time** (goods), and the other will be fulfilled **over time** (service).
    end note

note left of Step3_Determine_Transaction_Price
        The transaction price is the amount of consideration (payment) the entity expects to receive in exchange for transferring goods or services to the customer. This can include fixed and variable amounts (such as discounts, rebates, or performance bonuses).
    end note

note right of Step4_Allocate_Price
        If the contract has multiple performance obligations, the transaction price needs to be allocated to each performance obligation based on their relative standalone selling prices.
    end note

Step 1: Identify the contract with a customer

ASC 606 and IFRS 15 both require an entity to identify the contracts with a customer. A contract is an agreement between two or more parties that creates enforceable rights and obligations. The contract must meet specific criteria, including:

• The agreement must be legally binding.
• The parties have agreed to the terms, including the identification of goods or services to be transferred.
• The payment terms are identifiable.
• The contract has commercial substance, meaning it is expected to result in a transfer of economic benefits.
• It is probable that the entity will collect the consideration to which it is entitled.

The identification of the contract forms the basis for the subsequent revenue recognition process.

Step 2: Identify the performance obligations in the contract

• A performance obligation is a promise to transfer a prodduct or service to a customer that is distinct. An entity must identify all the distinct performance obligations in the contract. If a good or service is not distinct on its own, it may need to be combined with other goods or services to form a single performance obligation.
• A goods or service is considered distinct if:
  • The customer can benefit from the good or service on its own or together with other resources.
  • The promise to transfer the good or service is separately identifiable from other promises in the contract.

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Note

Performance obligations are not always explicitly stated in a contract but are derived through a detailed analysis of the terms and promises made between the entity and the customer. These obligations are identified based on the specific goods or services the entity is committed to delivering, which may not always be clearly outlined in the contract's language. Once identified, performance obligations are tracked and managed separately within an entity’s ERP or financial system. These systems help ensure that each obligation is met according to the contract’s timeline and conditions, allowing for proper revenue recognition and compliance with standards like ASC 606 and IFRS 15. As performance obligations are fulfilled, revenue is recognized in alignment with the satisfaction of these obligations.

Step 3: Determine the transaction price

• The transaction price is the amount of consideration the entity expects to receive in exchange for transferring the promised goods or services to the customer. It may include various elements such as:
  • Fixed amounts or variable amounts (e.g., discounts, rebates, performance bonuses).
  • Non-cash consideration (e.g., barter or stock).
  • Consideration payable to the customer (e.g., rebates or incentives).
• The transaction price must be determined by considering the total amount of consideration expected to be received, adjusting for any variable elements and ensuring that the entity’s performance obligation is measured accurately.

Step 4: Allocate the transaction price to the performance obligations in the contract

• If the contract has more than one performance obligation, the transaction price must be allocated to each obligation. The allocation is based on the relative standalone selling prices of the distinct goods or services.
• If standalone prices are not directly observable, an estimate of the standalone price is made using one of several methods, such as adjusted market assessment, expected cost plus margin approach, or residual value method.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation

Revenue is recognized when or as the entity satisfies each performance obligation. The satisfaction occurs when the control of the good or service is transferred to the customer.

• Point in time: Revenue is recognized when control of the good or service passes to the customer, which may happen at a specific point in time (e.g., delivery of goods).
• Over time: Revenue is recognized over time as the performance obligation is satisfied, which is common for long-term contracts or services provided over a period of time (e.g., construction projects or subscriptions).

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Revenue is earned, not received

Revenue is recognized when it is earned — i.e., when the entity has completed its part of the deal and the customer has control over the good or service. The timing of the payment, however, is not directly tied to revenue recognition. For instance, a business might deliver a good in December but receive payment in January. The revenue is still recognized in December when the good is delivered, not when the payment is received.

To determine whether a performance obligation is satisfied over time, entities need to evaluate the nature of the transfer of control. In many cases, entities will use an appropriate method of measuring progress, such as output methods (e.g., milestones or units delivered) or input methods (e.g., costs incurred or labor hours used).

The five-step model in ASC 606 and IFRS 15 ensures that revenue is recognized in a consistent, transparent, and comparable manner. These steps guide entities in identifying contracts, determining performance obligations, allocating transaction prices, and recognizing revenue in accordance with when the performance obligations are satisfied. The framework aims to provide stakeholders with a clearer, more accurate reflection of an entity's financial performance by aligning revenue recognition with the actual transfer of control of goods or services to customers.