Revenue recognition is one of the General Accepted Accounting Principles (GAAP) that identifies the specific circumstances under which the revenue is recognized and determines how to be accounted for. It is usually recognized when a critical event occurs, and its dollar amount is easily measurable.
Planning and adhering to Account Standard Codification No. 606, revenue gotten from Contracts with Customers may be more complicated than many businesses realize. However, the complex standard represents a fundamental and significant change in accounting, and it supersedes all current revenue recognition guidance, including the industry-specific ones.
If you look at the positive side, the adoption and implementation of the new standard give us an excellent opportunity to consider strategic, operational issues like increasing efficiency, improving information systems, and strengthening the processes and controls.
Key Things for Implementing Revenue Recognition
1. Implementation Throughout the Company
Even though the new standard’s framework is intended to promote consistency in how the companies evaluate revenue recognition, the new standard is quite complex and, in many circumstances, requires more judgments and estimates.
It will require more processes, controls, and documentation and possibly significant changes to existing information technology (IT) systems or the implementation of new IT solutions. That is why implementation requires the participation and coordination of different departments within an organization.
2. Implementation and Its Results
The new standard has two methods of implementation: complete retrospective and modified retrospective. The companies must use the new standards as if they are working since the start of all contracts with customers reflected in the financial statements under the complete retrospective approach, subject to certain practical expedients, resulting in a restatement of the prior-period financial statements.
Even though this form of implementation requires additional work, it allows all the contracts with the customers to be recognized and measured consistently throughout all periods shown in the financial statements, regardless of the contact initiation. This strategy also offers financial statement users important trend information for all periods.
Companies will retrospectively apply the guidelines only to the most recent period shown in the financial statements under the modified retrospective method, resulting in the recording of a cumulative impact adjustment to the open balance of retained earnings as the date of initial application. Even though the modified retrospective adoption strategy appears to be the simplest method of adoption, this is not always the case.
Under this system, the corporations must report the amount by which each financial statement line item was affected due to adopting the new standard in the year of adoption and explaining significant changes, resulting in an obligation to maintain two separate accounting books.
Furthermore, financial statement comparability may be compromised because earlier periods will continue to be presented following historic generally accepted accounting principles (GAAP).
3. Five-Step Model
i. Identifying Customer Contracts
Contract with a customer contains several features; the most important is that the contract does not need to be in writing. However, it should have the following:
- Substance for sale.
- Parties committed to upholding their end of the bargain.
- Payment terms and rights that can be identified.
- Possibility of collection.
ii. Setting Performance Obligations
The contract is recognized as a good or service. If it is different, it must be taken into account as a separate service obligation for the company, meaning that your customer can benefit from the good or service on its own. The promise of transferring the good or service is different from other contract commitments. The performance duties in contracts might be single or more.
iii. Determining Your Transaction Price
Several factors influence your transaction price, including:
- Variable considerations include discounts, credits, incentives, price concessions, etc.
- The transaction price changes over the contract’s life should be assigned in the same manner as during contract inception Customer return and rebate rights can result in variable considerations. For these conclusions, you must review the customer history.
Keeping this consideration in mind, only the consideration you expect to get is reported as revenue.
iv. Valuation of The Contract Based on Performance
When there are different responsibilities, the corporation needs to decide how to allocate the consideration from the contract’s start. This can be based on the standalone cost of the obligations, or the company can anticipate it based on previous experience.
v. Recognizing the Revenue on Meeting a Performance Goal
The most important consideration is to know whether revenue is recognized at a “once in time” or “over time.” When commitments meet over time, either the input or output technique should be utilized to track progress.
These steps involve essential decisions and require a thorough review, documentation, and disclosure. For example, if you want a good or service in a contract to represent a performance obligation, it must be different in the context of this contract. This can result in considerable differences between performance obligations under the new standard and separate accounting units under legacy GAAP.
Not only does the new standard influence revenue recognition, but it also has the potential to have a significant impact on contract acquisition and contract fulfillment expenses. This is important because these changes need the capitalization and amortization of previously expensed costs that may extend beyond the contract duration.
Revenue Recognition is Only the Beginning
Finally, the new standard is just the beginning of the accounting reforms that will affect businesses. For example, the new lease accounting guidance, likewise complex and impacts all enterprises, goes into effect just one year after the new revenue norm.
As a result, the implementation overlaps. In addition, there are other accounting efforts in the pipeline that will impact financial instrument accounting and other sectors.
Why Does GAAP Require the Accounting of Revenue?
According to GAAP, Revenue must be recognized following the revenue recognition principle, an essential part of accrual accounting. Therefore, the revenue is recorded on the income statement period in which it is released and earned rather than when cash is received.
In addition, it must be wholly or essentially complete for the revenue-generating activity to be included in revenue during the accounting period. Also, there should be a significant certainty level that the earned revenue payment will be received as promised.
Lastly, according to the matching principle, you must report the revenue and its costs in the same accounting period.
Revenue Recognition – A Necessary Implementation
Revenue recognition is essential because it directly relates to the integrity of its financial reporting. The goal of revenue recognition is to standardize companies’ revenue policies. The standardization enables external entities like analysts and investors to quickly compare the income statements of different companies in the same industry. Hence implementation of this is very much beneficial and necessary.