When do payments become revenue?
2019 – 08/06 You’ve received a $10,000 payment from a customer. Does that mean your revenue for the month has increased by $10,000? Can you immediately describe that $10,000 as revenue if you are applying for a loan or discussing a possible sale of your business? This is the crux of revenue recognition – when do payments become revenue?
Rules now going into effect create a standard for revenue recognition across all industries.
In May 2014, the Federal Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a converged standard regarding revenue recognition, ASU 2014-09, Revenue from Contracts with Customers. This standard, replacing rules and practices that often varied from industry to industry, introduces a comprehensive framework for recognizing revenue in accordance with generally accepted accounting principles (GAAP).
When did you deliver?
If you operate a retail business where customers pay when they take home their merchandise, those payments generally constitute revenue as soon as they are received.
But what if you have a subscription business model, where customers pay now for goods or services received over the next year? Or a project-based business where an upfront payment covers work for the next six months?
Under the converged standard, the key timing is when control of the good or service passes to the buyer, not when the seller receives payment. For a consulting business that offers a monthly newsletter subscription for a one-time annual payment of $1200, revenue would be recognized at $100 per month.
How it works
The standard spells out the variables that dictate how and when revenue should be recognized. It includes a five-step model, with key elements described below*:
Part 1 – Identify customer contract. This standard only applies to contracts with customers. A customer is a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration. A contract is an agreement between two or more parties that creates enforceable rights and obligations. Contracts can be written, but in many cases are not.
Part 2 – Identify performance obligations in the contract. A performance obligation is a promise to a customer to transfer a distinct good or service, a distinct bundle of goods or services, or a series of distinct goods or services that are substantially the same and are transferred to the customer in the same pattern. For instance, an online media company might contract with a customer to deliver a series of ads on various web sites over several months.
Part 3 – Determine the price of the transaction. The transaction price is the amount that an entity expects to be entitled for providing promised goods or services to the customer. When an exact price of the transaction may vary, the consideration should be estimated at the inception of the contract. The variable consideration should be estimated using either the expected value or the most likely amount for the transaction.
Part 4 – Allocate the transaction price. If the contract has more than one performance obligation, the transaction price should be allocated to each performance obligation based on the relative standalone selling price of the relevant good or service – the price an entity would charge if it were to sell the good or services separately. When observable standalone selling prices are not available, the entity should estimate the amount considering all available information.
Part 5 – Recognize Revenue. Revenue should be recognized when, or as, the performance obligation if satisfied. The performance obligation is satisfied when the good or service is transferred to the customer, which occurs when the customer obtains control of the good or service. This transfer may occur at a single point of time or over a period of time.
When the standard takes effect
This standard comes into effect for annual reporting periods beginning after December 15, 2018, and interim periods within annual reporting periods beginning after December 15, 2019. For private entities with a December 31 year-end, the adoption should be the year ended December 31, 2019.
This standard will require additional disclosures for the financial statement presentation. Private entities will be required to disclose information that assists users in understanding the nature, timing, amount, and uncertainty of revenues and cash flows associated with customer contracts.
Bland Garvey can help you understand how the revenue recognition standard applies to your business and how to comply with its requirements.
*For full text, consult 402.1 FASB ASU 2014-09, Revenue from Contracts with Customers (Topic 606),