Accounting: The Language of Business - Vol. 2 (Intermediate: Part 115)

“The most successful entrepreneurs I know are optimistic. It’s part of the job description.”
— Caterina Fake, co-founder of Flickr

 Revenue Recognition (Part B)

by

Charles Lamson

 THE CONCEPTUAL FRAMEWORK

Revenue Recognition

The conceptual framework outlines the objectives of financial reporting and the qualities of good accounting information, precisely defines commonly used terms such as asset and revenue, and provides guidance about appropriate recognition, measurement, and reporting (MyEducator).

The revenue recognition standards discussed in the next series of parts of this analysis are relatively new and are effective for public companies with fiscal years beginning after December 15th, 2017. They are not completely aligned with the conceptual framework. That is, the revenue recognition standards indicate that the overarching principle of revenue recognition is the notion of the transfer of control of the goods or services. In contrast, the current conceptual framework does not mention transfer of control but rather states that a company recognizes revenue when it meets two conditions:

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1. The revenue has been earned, and

2.  the revenue is realized (revenue that a company has already received) or realizable (when revenues are readily convertible to cash or claim to cash).

Although transfer of control often occurs simultaneously with the culmination of the earning process, there are scenarios in which they do not happen at the same time. How then can the standards and the conceptual framework that both come from the Financial Accounting Standards Board (FASB) conflict? The FASB is currently in the process of rewriting the conceptual framework. we expect that the FASB will align the conceptual framework with the new standard when it rewrites the framework. 

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In the next several parts, we cover each of the five steps (Exhibit 8.1 from Part 114, and reintroduced below) in the revenue recognition process in depth. In this post we focus on Step 1: Identify the Contract(s) with a Customer. Note that we do not actually record a journal entry until the 5th step. The point of the five step approach is to determine when to recognize revenue and how much revenue to recognize. Thus, we will not know the proper journal entry to record the sale until we complete the entire process.

Step 1: Identify the Contract(s) with a Customer

The first step in the revenue recognition process is to identify the contract, or contracts with the customer. A contract is an agreement between two or more parties that creates enforceable rights and obligations (FASB ASC 606-10-20 - Revenue from Contracts with Customers - Overall - Glossary).

Contract Criteria

If the seller meets the following five criteria related to the contract, then it continues through the remaining four steps to determine the timing and measurement of revenue recognition.

1. All parties to the contract have agreed to the contract and are committed to performing under the contract. The approval by the parties can be in writing, provided orally, or implied by an entity's customary business practices.

2. Each party's rights with respect to the goods or services that are being transferred are identifiable.

3. The payment terms for the goods or services that are being transferred are identifiable.

4. The contract has commercial substance, meaning that the risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract.

5. It is probable that the seller will collect the consideration to which it is entitled in exchange for the goods or services. To assess the probability of collection, the seller considers the customer's ability and intention to pay this specific amount of consideration when it is due.

For purposes of the fifth criterion, Generally Accepted Accounting Principles (GAAP or U.S. GAAP) defines probable as “ likely to occur.” The seller assesses collectability on the expected consideration (the estimated transaction price), not the contract price. For example, if the seller intends to offer a price concession, which is a reduction in the contract price, then the estimated transaction price will be less than the contract price.

Also related to the fifth criterion, the company should consider only the amount that is at risk of not being collected, which may be less than the entire consideration. For example, if the customer is required to pay a portion of the consideration before delivery, then the seller would consider only the probability of collecting the amounts due after delivery. Or, if the seller is contractually allowed to stop transferring goods or services should the customer fail to pay, then only the consideration related to the goods or services that would be delivered is considered. Exhibit 8.2 summarizes the five criteria to identify a contract with customers.

Example 8.2 illustrates the collectability assessment.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 375-377*

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