Accounting: The Language of Business - Vol. 2 (Intermediate: Part 114)

“Do not focus on numbers. Focus on doing what you do best. It’s about building a community who want to visit your site every day because you create value and offer expertise.”
— Cassey Ho

 

Revenue Recognition (Part A)

by

Charles Lamson

Introduction

Revenue is the first line item on any company's income statement. Depending on the nature of a company's business, revenue may be called sales revenue, rental revenue, royalty revenue, investment revenue, or service revenue. Some revenues are accounted for easily, such as Target recording sales revenue for a customer purchase. Other sales transactions are more complex due to timing issues related to when the company should recognize the revenue.

When to record revenue is an important issue in many companies. Consider the purchase of a Kindle from Amazon. A Kindle buyer typically receives the device, wireless access, and software upgrades. That is, the buyer pays one sales price and receives multiple items. What does Amazon record as a sale—the sale of the Kindle, the wireless service, the software upgrades, or the sum of all three? In practice, Amazon allocates the sales price to these three items, recording the revenue for each item in different time periods based on when it transfers the good or service. That is, the seller recognizes the revenue related to the device, which is a substantial portion of the sales price on the date of the delivery. Amazon then recognizes revenues related to wireless access and software upgrades as it provides the services over the average life of the device.

In the next several parts of this analysis, we discuss revenue recognition and the primary accounting issues of determining the timing and amount of revenue recognition. Usually, a company recognizes revenue when it delivers a good or provides a service. Sometimes a company recognizes revenue before the delivery of a good, such as with long-term construction contracts. We will also discuss these scenarios and other more complex revenue recognition cases. The revenue recognition standard is fully converged between U.S. GAAP and IFRS. 

Revenue Recognition Overview

Revenue recognition involves issues dealing with both timing (i.e., when revenue is recognized) and measurement (i.e., how much is recognized). With regard to timing, the fundamental principle of revenue recognition is that a company should recognize revenue when it transfers control of an asset (either a good or service) to the customer. With regard to measurement, the fundamental principle is that a company should recognize the amount of revenue that it expects to be entitled to receive in exchange for the goods or services. Finally, the company recognizes revenue as it satisfies each performance obligation.

In order to accomplish these objectives of revenue recognition, companies must follow five steps. These five steps are outlined in Exhibit 8.1.

The seller must meet the Step 1 requirement, to identify the contract, in order to continue with the revenue recognition process. Once the contract is identified, the seller must identify both the separate performance obligations (Step 2) and the transaction price (Step 3) in order to continue with Step 4. Step 4 takes the transaction price that is determined in Step 3 and allocates it to the separate performance obligations that are identified in Step 2. Once the seller has identified the separate performance obligations and has a price attached to each, it determines the appropriate timing for the recognition of revenue for each performance obligation separately. Example 8.1 provides a simplified illustration of the five-step approach to provide a conceptual understanding of the steps. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 373-375*

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