AICPA Guidance on the Revenue Recognition Standard

Revenue recognition is an accounting process that determines when and how much income is recorded. Proper application is necessary for creating reliable financial statements that reflect a company’s performance. The primary standard governing this area is the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers, which replaced most previous guidance with a unified framework.

While the FASB sets authoritative U.S. Generally Accepted Accounting Principles (GAAP), the American Institute of Certified Public Accountants (AICPA) develops nonauthoritative implementation guidance and educational resources. These tools assist management and auditors in applying the principles of the standard to complex scenarios. This helps ensure that financial reporting is consistent and comparable across different companies and industries.

The Core Principle of Revenue Recognition

The principle of the revenue recognition standard is to record revenue to show the transfer of goods or services to customers for the amount the company expects to receive. This principles-based approach demands greater use of judgment compared to older, rules-based guidance. The entire five-step model is built to achieve this objective.

A key element of this principle is the concept of “transfer of control.” A company recognizes revenue only when a customer gains control of a good or service. Control is defined as the ability to direct the use of the asset and obtain substantially all of its remaining benefits. This means the customer can decide how to use the item and is the primary beneficiary of its economic value.

This focus on control is a departure from the previous emphasis on the “risks and rewards” of ownership. The new standard provides a more robust framework by concentrating on which party is directing the economic benefits of the good or service. This change was intended to remove inconsistencies and improve the comparability of revenue practices.

The Five-Step Model for Revenue Recognition

The revenue recognition standard provides a five-step process for companies to follow. This model is a systematic framework that guides entities through identifying contractual obligations, determining the transaction amount, and recognizing revenue at the appropriate time.

Identify the Contract(s) with a Customer

The first step is to determine if a contract exists. A contract is an agreement between two or more parties that creates enforceable rights and obligations. For accounting purposes, a contract must meet five criteria. The parties must have approved the agreement, the company must be able to identify each party’s rights, and the payment terms must be identifiable.

The contract must also have “commercial substance,” meaning the transaction is expected to change the company’s future cash flows. Finally, it must be probable that the company will collect the consideration it is entitled to. If a contract does not meet all these criteria, the company must re-evaluate it in subsequent periods.

For example, a company sells a machine for $100,000, which includes installation for $5,000 and one year of support for $3,000. The agreement is signed, payment terms are defined, the deal has commercial substance, and collection is probable. This agreement meets the criteria and is identified as the contract.

Identify the Performance Obligations

The second step involves identifying the distinct promises within the contract, known as performance obligations. A performance obligation is a promise to transfer a good or service to a customer. A good or service is distinct if the customer can benefit from it on its own or with other resources, and the promise to transfer it is separately identifiable from other promises in the contract.

This evaluation requires judgment to determine whether multiple promises are part of one larger deliverable or should be accounted for separately. The goal is to break down the contract into the individual units for which revenue will be recognized.

In the machine example, the delivery of the machine, the installation service, and the technical support are three separate promises. Each is distinct because the customer could benefit from the machine on its own, and the installation and support services are not highly integrated with it. Therefore, the contract contains three performance obligations.

Determine the Transaction Price

The third step is to determine the transaction price, which is the amount of consideration the company expects to receive. This amount may be fixed or include variable components, such as discounts, rebates, or performance bonuses. When consideration is variable, a company must estimate the amount using either the expected value method (a sum of probability-weighted amounts) or the most likely amount method (the single most likely outcome).

An entity can only include an estimated amount of variable consideration in the transaction price to the extent that it is probable that a significant reversal in cumulative revenue will not occur when the uncertainty is resolved. This constraint requires companies to be cautious and avoid recognizing revenue that might have to be reversed. The transaction price also needs to be adjusted for the time value of money if the contract includes a significant financing component.

In the example, the stated price is $108,000. The contract offers a 2% discount ($2,000) on the machine if paid within 10 days. Based on history, the company determines the customer will likely take the discount. Therefore, the transaction price is determined to be $106,000.

Allocate the Transaction Price

In the fourth step, the company allocates the transaction price to each separate performance obligation based on its relative standalone selling price. The standalone selling price is the price at which the company would sell a good or service separately. If standalone selling prices are not directly observable, they must be estimated.

Common estimation methods include the adjusted market assessment approach, the expected cost plus a margin approach, or the residual approach, which is used in limited circumstances. The objective is to distribute the transaction price to reflect the consideration the company expects for satisfying each obligation.

Using the ongoing example, the $106,000 transaction price is allocated to the three performance obligations based on their standalone prices ($100,000 for the machine, $5,000 for installation, and $3,000 for support). The allocation is: Machine: $98,148, Installation: $4,907, and Support: $2,945.

Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation

The final step is to recognize revenue when, or as, each performance obligation is satisfied by transferring control of the promised good or service to the customer. An obligation can be satisfied either at a “point in time” or “over time.” Revenue is recognized over time if the customer simultaneously receives and consumes the benefits of the company’s performance.

If the criteria for recognizing revenue over time are not met, the company recognizes revenue at the point in time when control is transferred. Indicators of the transfer of control include the company having a present right to payment, the customer having legal title, and the customer having physical possession of the asset.

For the machine example, the $98,148 for the machine is recognized at a point in time when it is delivered. The $4,907 for installation is recognized when the service is complete. The $2,945 for support is recognized over the one-year support period, as the customer receives the benefit continuously.

Key Application Guidance

Beyond the five-step model, the standard includes specific guidance for handling common situations to ensure principles are applied consistently.

Contract Modifications

A contract modification is a change in the scope or price of a contract that is approved by the parties. If the modification adds distinct goods or services at their standalone selling prices, it is treated as a new, separate contract.

If it does not meet the criteria for a separate contract, it is accounted for as an adjustment to the original one. This can be treated as a termination of the old contract and the creation of a new one if the remaining goods or services are distinct. Alternatively, the modification can be treated as a cumulative catch-up adjustment to the revenue on the original contract.

Contract Costs

The guidance also addresses the accounting for costs related to contracts. Costs incurred to obtain a contract, such as sales commissions, are recognized as an asset if the entity expects to recover them. This asset is then amortized on a basis consistent with the transfer of the related goods or services.

Similarly, costs incurred to fulfill a contract are recognized as an asset if they meet certain criteria. These costs must relate directly to a contract, generate or enhance resources for future performance, and be expected to be recovered. These capitalized costs are amortized as the related revenue is recognized.

Presentation and Disclosure Requirements

The results of the five-step model must be correctly presented on the financial statements and explained in the notes. The standard introduced new rules to provide users with more comprehensive information about a company’s revenue.

Financial Statement Presentation

The standard requires entities to present contract-related assets and liabilities on the balance sheet. A “contract asset” arises when an entity has recognized revenue but does not yet have an unconditional right to payment. This differs from a traditional accounts receivable, where the right to consideration is unconditional except for the passage of time.

A “contract liability” is recorded when a customer pays consideration before the company transfers the related goods or services. This represents the company’s obligation to provide goods or services for which it has already been paid. These accounts provide transparency into timing differences between revenue recognition and cash flows.

Disclosure Objectives

The objective of the disclosure requirements is to help users of financial statements understand the nature, amount, timing, and uncertainty of revenue and cash flows from contracts. To achieve this, companies must provide quantitative and qualitative information, including a disaggregation of revenue into categories that show how revenue is affected by economic factors.

Companies must also disclose information about their performance obligations, including when they are satisfied and the transaction price allocated to remaining obligations. Disclosures must also explain the significant judgments made in applying the guidance, such as those related to the timing of revenue recognition and the transaction price.