Revenue recognition: the five-step model

When does a company count a sale as revenue?

When control of what it promised passes to the customer, not when cash moves. Under accrual accounting a credit sale creates revenue and a receivable at once, and cash received before delivery creates a liability instead. That liability is unearned revenue , also called deferred revenue.

Since 2018 International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (GAAP) share one standard, so revenue recognition works the same way under both.

What are the five steps?

Memorize

Contract, obligations, price, allocate, recognize. The five steps run in that order for every sale, from a coffee to a ten-year construction contract.

1. Identify the contract with a customer : enforceable rights, clear payment terms, commercial substance, and collection that is probable.
2. Identify the separate performance obligation s: each distinct good or service promised.
3. Determine the transaction price , including variable consideration such as bonuses or rebates only to the extent a significant reversal is unlikely.
4. Allocate the price to the obligations in proportion to their stand-alone selling prices.
5. Recognize revenue when (or as) each obligation is satisfied.

Step 4 is the one you calculate.

$$X_i = T \times \frac{S_i}{\sum S}$$

Questions ask for the allocation, or work back from an allocation to the bundle price.

Over time or at a point in time?

Over time if the customer gets the benefit as you work, controls the asset you are building, or the asset has no other use to you and you have a right to payment for work done. Otherwise recognition waits for a point in time, when control passes.

An obligation satisfied over time produces revenue gradually as the work is done. One satisfied at a single moment produces it all at once.

Revenue recognitionwhen control of the good or service passes to the customer

• Over time Use it any one test is enough
  • Benefit consumed as you perform a subscription, a cleaning contract
  • Customer controls the asset as it is built a building on their land
  • No alternative use plus right to payment made-to-order equipment
• Point in time Use it control passes at one moment
  • Signals of the transfer title, possession, acceptance, right to payment

Software shows both: a license the customer installs and that you do not keep changing is a point in time sale, usually recognized up front, while cloud access is recognized over time. The exam labels this software license vs software as a service .

How do you recognize revenue on a long-term contract?

Use it

Measure progress as costs incurred to date over total expected costs, then apply that percentage to the price. A long-term contract that meets an over-time test is recognized this way.

$$\%\ \text{complete} = \frac{\text{costs incurred to date}}{\text{total expected costs}}$$

$$\text{Revenue} = P \times \%\ \text{complete}, \qquad \text{Profit} = \text{Revenue} - \text{costs to date}$$

If the contract is expected to lose money, recognize the entire expected loss immediately. A EUR 50 million contract with expected total costs of EUR 56 million is a EUR 6 million loss, and all 6 is recognized in the first year, not spread across the life of the contract.

Exam tip Cost to cost gives the percentage. Revenue is price times that percentage; profit is revenue minus the costs incurred, never price minus cost.

Who reports the gross amount: principal or agent?

The principal. A principal vs agent test asks who controls the good or service before it goes to the customer. The one that does, and bears the inventory and price risk, reports the full price. The one that merely arranges the sale reports its fee.

Same profit, very different revenue and margins. A company that shifts from principal to agent sales reports lower revenue and a higher margin with no change in economics.

Common revenue situations

• Long-term contract Use it over time, progress measured as cost to date over total expected cost
  • Expected profit recognize in proportion to progress
  • Expected loss recognize all of it at once
• Principal or agent Use it
  • Principal gross revenue
  • Agent net fee
• Software Use it
  • Installed license point in time, usually up front
  • Cloud access over time
• Costs of winning the contract Know the idea incremental ones, like a sales commission, are capitalized and amortized

What does this mean for analysis?

Allowed judgments change the timing and size of revenue, so compare like with like. Progress estimates, principal or agent status and variable consideration are all judgments. Where the notes give enough detail, adjust; otherwise rank companies as more or less conservative.

Read these disclosures: contract assets and liabilities, remaining performance obligations, and the significant judgments management made. Incremental contract costs of winning a deal, such as a sales commission, are capitalized and amortized over the contract. That spreads the cost to match the revenue.

Go deeper Variable consideration and the constraint

Prices often include discounts, rebates, refunds or bonuses. The company estimates the amount using either an expected value (probability-weighted) or the single most likely amount, whichever predicts better. It then includes the estimate in the transaction price only to the extent a significant reversal of cumulative revenue is unlikely. This “constraint” stops revenue being booked early on amounts that may never be collected.

Go deeper Contract modifications and bill-and-hold

A contract modification is treated as a separate contract if it adds distinct goods at stand-alone prices; otherwise it is folded into the existing contract. In a bill-and-hold sale the customer is invoiced but the goods stay with the seller. Revenue is recognized only if control has genuinely passed, which is a classic aggressive-reporting flag (see reporting quality).

Go deeper Why the standard was converged

Before 2018 US GAAP had many industry-specific revenue rules and IFRS had thinner, principle-based ones, so similar deals produced different revenue. The converged model uses one principle (transfer of control) for every industry, which makes revenue more comparable across companies and borders.