Revenue recognition refers to the accounting rules that govern the amount of revenue which a company can recognize in a given period.
Under U.S. GAAP, the general principal for recognizing revenue is to record revenues when they are earned – i.e., when the services have been performed or the goods have been provided to customers.
In 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) Topic 606. This revised revenue recognition framework was the result of a years-long effort to bring convergence between U.S. GAAP and International Financial Reporting Standards (IFRS), which are the reporting standards used in many parts of the world.
Under ASC Topic 606 (Revenues from Contracts with Customers), companies must follow a five-step approach to revenue recognition:
- Identify the contract(s) with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognize revenue when (or as) the entity satisfies a performance obligation
A contract between a company and its customer is an explicit or implicit agreement that establishes each party’s rights and obligations under the contract. Under U.S. GAAP, collection must be likely for the contract to exist.
Performance obligations are the promises to transfer goods or services. Distinct performance obligations within the contract must be accounted for separately.
The transaction price represents the expected payment for the fulfillment of the performance obligation. The company must then separately allocate the transaction price to the distinct performance obligations in the contract.
The company recognizes revenue when the performance obligation has been satisfied. Satisfaction of the performance obligation occurs when the company deems it highly unlikely that the customer will request a refund for the good or service.
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