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. It 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.

Key principles of revenue recognition:

1. Transfer of control: Revenue is recognized when the customer gains control of the asset. This transfer of control may occur either at a specific point in time (e.g., delivery of goods) or over time (e.g., completion of a service).

2. Performance obligations: A performance obligation is a promise within a contract to transfer goods or services that are distinct. Revenue is recognized when these obligations are fulfilled, reflecting the delivery or completion of the promised goods or services.

3. Transaction price: The transaction price is the amount the entity expects to receive in exchange for transferring the goods or services. Revenue is recognized in accordance with this price, which may include variable amounts such as discounts, rebates, or performance bonuses.

4. Allocation of transaction price: If a contract includes multiple performance obligations, the total transaction price is allocated to each obligation based on their relative standalone selling prices.

5. Timing of recognition: Revenue is recognized either over time or at a point in time, depending on how the performance obligations are satisfied. Over time recognition applies when control is transferred progressively, while point-in-time recognition occurs when control is transferred at a specific moment.

Revenue recognition ensures that revenue is reported in the period in which the entity has fulfilled its performance obligations, providing a more accurate reflection of the entity's financial performance and position. By aligning the recognition of revenue with the transfer of control, entities can offer stakeholders reliable, transparent, and comparable financial information.

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.

Step 1: Identify the contract with a customer

ASC 606 and IFRS 15 both require an entity to identify the contract(s) 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 good or service to a customer that is distinct. In step 2, 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 good 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.

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).

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.

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 company, 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