How to Recognize Revenue From Contracts With Customers

The accounting standard ASC 606 provides a unified framework for recognizing revenue from contracts with customers, aiming to increase the comparability and transparency of revenue reporting. The core principle is to recognize revenue in a way that illustrates the transfer of promised goods or services to customers. The amount recognized should reflect the payment the company expects to receive in exchange for those goods or services.

Step 1 Identify the Contract with a Customer

The initial step in revenue recognition is to confirm a valid contract with a customer, which is an agreement that creates enforceable rights and obligations. For accounting purposes under ASC 606, an agreement must meet five specific criteria to be considered a contract.

• The parties have approved the contract and are committed to fulfilling their obligations, which can be in writing, verbal, or implied by business practices.
• The rights of each party concerning the goods or services to be transferred are identifiable.
• The payment terms for the goods and services, including price and due dates, are identifiable.
• The contract has commercial substance, meaning the transaction is expected to change the company’s future cash flows.
• It is probable that the entity will collect the consideration it is entitled to, based on the customer’s ability and intention to pay.

If a contract does not meet all five criteria, revenue recognition is deferred until they are met. If two contracts are entered into at or near the same time with the same customer, they may be combined and treated as a single contract.

Step 2 Identify Performance Obligations

Once a contract is identified, the next step is to pinpoint the specific promises made to the customer, known as performance obligations. A performance obligation is a promise to transfer a good or service to a customer. A contract may contain a single obligation or multiple obligations, such as selling a product and also providing installation and maintenance services.

A good or service is considered “distinct” if it meets two criteria. The first is that the customer can benefit from the good or service on its own or with other readily available resources, meaning the item has standalone value. For example, a software license has value on its own, as the customer can use it without other services from the seller.

The second criterion is that the promise to transfer the good or service is separately identifiable from other promises in the contract. To assess this, a company considers if the good or service is integrated with, significantly modifies, or is highly dependent on other items. If a promise does not meet both criteria, it is bundled with other promises until a distinct bundle of goods or services is identified.

Consider a company that sells a software license, performs the installation, and provides one year of technical support. The software license is distinct because the customer can use it on its own. The installation service might be distinct if the customer could hire another company to perform it. The technical support is also typically distinct, resulting in three separate performance obligations.

Step 3 Determine the Transaction Price

After identifying the performance obligations, the third step is to determine the transaction price. The transaction price is the amount of consideration a company expects to be entitled to in exchange for transferring the promised goods or services to a customer.

Many contracts include variable consideration, affected by discounts, rebates, or performance bonuses. A company must estimate this amount using one of two methods: the expected value method (a sum of probability-weighted amounts) or the most likely amount method (the single most likely amount). The chosen method should be the one the company expects will better predict the final amount.

Another factor is the time value of money. If the contract includes a significant financing component, meaning a long period between payment and the transfer of goods, the transaction price must be adjusted. This adjustment accounts for interest by discounting the price to its present value.

The transaction price must also account for any noncash consideration, measured at its fair value. If fair value cannot be reasonably estimated, the standalone selling price of the goods or services is used instead. Any consideration payable to a customer, such as vouchers, is treated as a reduction of the transaction price.

Step 4 Allocate the Transaction Price

The fourth step is to allocate the total transaction price to each distinct performance obligation. The allocation is based on the relative standalone selling price of each distinct good or service promised in the contract. The standalone selling price is the price at which a company would sell a promised good or service separately to a customer.

The best evidence of a standalone selling price is the observable price of a good or service when the company sells it separately to similar customers. If a price is not directly observable, it must be estimated. There are several estimation methods, including the adjusted market assessment approach, which evaluates the market to estimate a price customers would pay. Another is the expected cost plus a margin approach, where the company forecasts costs and adds an appropriate margin.

A third method, the residual approach, may be used in limited circumstances. This approach allocates the remaining transaction price to an obligation after allocating to others with observable standalone prices. For example, if a total contract price is $15,000, the company would allocate this to the software license, installation, and support based on their standalone selling prices, such as $12,000, $1,000, and $2,000, respectively.

Step 5 Recognize Revenue

The final step is to recognize revenue when, or as, the company satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when the customer obtains control of it, which is the ability to direct its use and obtain its benefits. Revenue recognition can occur either at a point in time or over time.

A company recognizes revenue over time if one of three criteria is met. The first is if the customer simultaneously receives and consumes the benefits as the company performs. The second is if the company’s performance creates or enhances an asset that the customer controls as it is created. The third is if the performance does not create an asset with an alternative use, and the company has an enforceable right to payment for performance completed.

If an obligation is satisfied over time, revenue is recognized by measuring progress toward completion. This can be done using output methods, based on direct measurements of value to the customer, or input methods, based on the company’s efforts.

If none of the criteria for recognizing revenue over time are met, the obligation is satisfied at a point in time. To determine that point, a company considers indicators of the transfer of control, including:

• The company has a present right to payment.
• The customer has legal title to the asset.
• The company has transferred physical possession of the asset.
• The customer has the significant risks and rewards of ownership.
• The customer has accepted the asset.

In the software example, revenue from the license and installation would be recognized at a point in time. In contrast, revenue from technical support would be recognized over the one-year service period.