What Is the First Step to Follow for Revenue Recognition?

Revenue recognition in accounting is how businesses record the income they earn from selling goods or services. It ensures that revenue is recorded when a business fulfills its obligations to customers, rather than simply when cash is received, providing a clear picture of a company’s financial performance and economic substance for investors, creditors, and other stakeholders.

Identifying the Contract with a Customer

The initial step in recognizing revenue under Accounting Standards Codification (ASC) 606 is to identify the contract with a customer. A contract is an agreement that creates enforceable rights and obligations between two or more parties. This foundational step is paramount because it establishes the scope of the transaction and forms the basis for all subsequent revenue recognition analysis.

This step involves understanding the entire agreement, which can be in various forms, including written, oral, or implied by customary business practices. For instance, a software company might have a written agreement for software access, but also verbally agree to provide free implementation services. All these components contribute to the overall agreement. The identification of the contract ensures that the business has a legitimate basis for expecting payment and transferring goods or services.

Criteria for a Valid Contract

For a contract to be valid for revenue recognition, it must meet specific criteria:
The parties to the contract must have approved it and be committed to performing their respective obligations. This approval can be in writing, orally, or based on customary business practices.
The entity can identify each party’s rights regarding the goods or services to be transferred. This clarity ensures that both the business and the customer understand what they are entitled to receive and what they are obligated to provide.
The contract must also identify the payment terms for the goods or services to be transferred. This includes details about when and how the customer is expected to pay, such as payment schedules or credit terms.
The contract needs to have commercial substance, meaning the risk, timing, or amount of the entity’s future cash flows are expected to change as a result of the contract. This ensures that the transaction has a genuine economic impact on the business.
It must be probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services transferred to the customer.

Modifying and Combining Contracts

Contract modifications, which are changes to the scope or price of an existing contract, directly impact how the initial contract identification is treated. When a contract is modified, businesses must determine if the modification creates a new, separate contract or if it should be accounted for as part of the existing contract. A modification is treated as a separate contract if it adds distinct goods or services not included in the original agreement, and the price increase reflects the standalone selling price of these additional items.

If a modification does not meet these criteria to be a separate contract, the accounting depends on whether the remaining goods or services are distinct from those already transferred. If they are distinct, the modification is accounted for prospectively, as if the original contract was terminated and a new contract was created for the remaining obligations. The remaining consideration from the original contract, plus any new consideration from the modification, is allocated to the remaining performance obligations.

Sometimes, multiple contracts are so closely related that they must be combined and accounted for as a single contract from the outset. This occurs if the contracts are negotiated as a package with a single commercial objective, or if the amount of consideration in one contract depends on the performance of the other. For instance, if a business enters into two separate agreements with the same customer where payment for the second agreement is contingent upon the successful completion of the first, these would likely be combined. Combining contracts ensures that the economic reality of the overall arrangement is accurately reflected in the financial statements.