When to Record Revenue With Accrual Basis Accounting

Understanding Accrual Revenue Recognition

Accrual basis accounting records financial transactions when they occur, regardless of when cash changes hands. This method provides a more accurate representation of a company’s financial health by matching revenues with the expenses incurred to generate them in the same accounting period.

Revenue, in financial accounting, signifies an increase in economic benefits during an accounting period, resulting in increases in equity. Revenue is recognized when it is earned, not necessarily when cash is received. This means a company records revenue once it has substantially fulfilled its promise to provide goods or services to a customer, establishing a right to payment.

For instance, if a consulting firm completes a project in June but invoices in July with payment due in August, the revenue is recognized in June when the service was performed. Similarly, if a business ships products in September, even if payment terms allow 30 days, the revenue is recognized in September when the goods are transferred. This approach offers a clearer picture of an entity’s performance over time by aligning economic activity with its financial impact.

The Five-Step Revenue Recognition Model

Accrual accounting uses a five-step model to determine when to record revenue. This framework ensures consistency in how companies recognize revenue across industries and transaction types.

The first step is identifying the contract with a customer. A contract is an agreement between parties that creates enforceable rights and obligations. This includes identifying the parties, their rights regarding goods or services, payment terms, and confirming the contract has commercial substance. It must also be probable that the entity will collect the consideration.

The second step involves identifying the performance obligations within the contract. A performance obligation is a promise to transfer a distinct 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 readily available resources, and if the promise to transfer it is separately identifiable. For example, selling a product and providing installation might be two distinct performance obligations.

The third step is to determine the transaction price, which is the amount of consideration an entity expects to receive for transferring promised goods or services. This price can be fixed or variable, potentially including discounts or bonuses. Companies must estimate any variable consideration at the outset of the contract, incorporating only amounts where a significant reversal in recognized revenue is unlikely when the uncertainty is resolved.

Following the determination of the transaction price, the fourth step requires allocating that price to the identified performance obligations. If a contract contains multiple distinct performance obligations, the total transaction price is allocated to each based on its standalone selling price. If a standalone selling price is not directly observable, an entity must estimate it.

The fifth and final step is to recognize revenue when, or as, the entity satisfies a performance obligation. This satisfaction can occur either over time or at a specific point in time. Revenue is recognized over time if the customer simultaneously receives and consumes the benefits as the entity performs, such as with ongoing subscription services. Another scenario for over-time recognition is when the entity’s performance creates or enhances an asset that the customer controls as it is created or enhanced, or if the entity has an enforceable right to payment for performance completed to date and the asset has no alternative use.

Revenue is recognized at a point in time when control of the promised good or service is transferred to the customer. Indicators of control transfer include:
The entity having a present right to payment for the asset.
The customer having legal title to the asset.
The customer having physical possession of the asset.
The customer having the significant risks and rewards of ownership of the asset.
The customer accepting the asset.

For example, revenue from the sale of physical goods is typically recognized at the point of shipment or delivery, when these control indicators are met.

Practical Applications of Revenue Recognition

Applying the five-step revenue recognition model clarifies how companies account for diverse transactions. Understanding these applications helps illustrate the timing of revenue recording.

Consider a company that sells consumer electronics, such as a television. The contract (Step 1) is the purchase agreement. The performance obligation (Step 2) is the delivery of the television. The transaction price (Step 3) is the sales price, and since there’s only one obligation, the allocation (Step 4) is simple. Revenue is recognized (Step 5) when control of the television is transferred to the customer, usually upon shipment or delivery and acceptance.

Another common example involves a software company offering a monthly subscription service. The contract identifies the recurring service agreement (Step 1), and the performance obligation (Step 2) is providing access to the software for a defined period. The transaction price (Step 3) is the monthly subscription fee, allocated entirely to this single performance obligation (Step 4). Revenue is recognized over time (Step 5) as the customer simultaneously receives and consumes the benefits of the software access throughout the subscription period. For instance, if the monthly fee is $100, the company recognizes $100 of revenue each month as the service is provided.

A more complex situation might involve a construction company building a custom facility. The contract (Step 1) outlines the project, and the performance obligation (Step 2) is the facility’s construction. The transaction price (Step 3) is the total agreed-upon cost, allocated (Step 4) to this single obligation. Revenue for such a project is recognized over time (Step 5) because the entity’s performance creates an asset the customer controls as it is being built, or because the entity has an enforceable right to payment for performance completed to date. The company recognizes revenue periodically, often based on the percentage of completion.