Challenges to consider in auditing revenue recognition

For example, a business might allow customers to purchase credits to be used for different exercise classes. In this case, the business would record revenue as the customer uses each credit. Before you record revenue, you need to make sure that there’s clarity on your obligations to the customer. The term “performance obligation” refers to distinct goods that the seller has agreed to deliver. The joint standards outlined in ASC 606 and IFRS 15 require that companies adhere to a five-step revenue recognition model. A common question people have is whether companies record sales taxes in revenue.

1. Once it has been established that contract with customer exists, presence of performance obligation has to be checked in the contract.
2. This is where a number of SaaS companies trip up—since there aren’t any accounting standards, they fail to realize that they have to recognize the revenue for a service incrementally throughout the time window for that service.
3. If the good or service is different enough from each other, promises featured in the contract are handled separately.
4. Last but not least, it is important to ensure that the payment for the goods or services is likely to be received, which means that the customer’s credit risk should be evaluated before the contract is signed.
5. Prior to May 2014, revenue recognition policies were very problematic in both US GAAP and IFRS.

ASC 606 details what makes a good or service distinct enough from the other. On the Radar briefly summarizes emerging issues and trends related to the accounting and financial reporting topics addressed in our Roadmaps. Suppose a B2B SaaS business offers its clients the option to pick a specific type of pricing plan, such as quarterly, annual, or multi-year payment plans.

Using the information from step three, clients allocate the transaction price to each performance obligation identified in the contract on a relative stand-alone selling price basis. The stand-alone selling price is the price at which an entity would sell a promised good or service to a customer. For ecommerce businesses, payment is often received before the goods are delivered, but revenue isn’t recognized until control transfers.

That price can be based on standalone selling prices as determined by the service or good which is defined within the contract. If that selling price is not apparent, the entity will need to estimate what it is. Sometimes the contract will dictate that a discount is offered along with any other chosen variables. Requirements in ASC 606 detail when the entity can allot these variables to obligations. The revenue recognition standards apply to all contracts except for leases, insurance contracts and financial instruments. Contracts must identify all parties (usually your company and your client), the rights of each party and the payment terms.

Continue your revenue recognition learnings

Even though it has the word “revenue” in the name, accountants classify deferred revenue as a liability because it is technically money you owe your customers. People outside your company, like investors, will often require that your financial statements adhere to GAAP or IFRS. This is because they want you to recognize revenue in a way that is familiar, standardized, and not misleading. Entities often have difficulty determining the appropriate judgments to apply in the identification of performance obligations and the assessment of whether an entity is a principal or an agent, as described below. Not surprisingly, these are two topics of the revenue standard on which entities commonly seek the SEC staff’s views in prefiling submissions.

If your contract contains more than one good or service, identify and separate them. Revenue recognition matters to any company that collects money from its customers before it actually earns that money. GAAP, you may have heard of International Financial Reporting Standards (IFRS).

Step 2: Identify performance obligations in the contract.

For example, in a restaurant, the performance obligation is likely the service of meals to the customer. For instance, if you own a construction company and you are constructing a warehouse for your client and for making necessary food arrangements for the construction team at the site, you have built a canteen room for them. This cannot be treated as a distinct performance obligation as it will not be transferred under the contract to the customer. Revenue is recognized as performance obligations are satisfied, whether over time or at a specific point in time. The transaction price can include cash and non-cash compensation that the business will receive from the customer, per the contract. Businesses should factor in any discounts, prorations, upgrades, or pricing customizations.

During this step, businesses should itemize every distinct performance obligation. A good or service is considered distinct when it’s of value to the customer and can stand alone and be transferred independently of other goods or services in the contract. The key point to remember about this step is that revenue should be recognized either over time, or at a point in time, and that these two approaches are mutually exclusive from each other. Your contract should include the overall price of the goods or services you’re providing. Considerations that may affect the price include discounts, rebates, and bonuses.

The second step in applying the new revenue recognition standard is to identify the performance obligations in the contract. Therefore, performance obligations serve as the basis for how and when to recognize revenue. Management needs to evaluate whether to categorize multiple promised goods / services separately or as a single obligation. Generally accepted accounting principles require that revenues are recognized according to the revenue recognition principle, which is a feature of accrual accounting.

If Company A and Company B are acting as partners, then Company A can’t recognize the payments as revenue. Company A might have to categorize the payments as dividend payments or investment income. If Company B is a customer receiving service from Company A, then Company A may recognize the payment as revenue.

Revenue Recognition

It lays out the clear process and conditions that companies must follow in order to recognize any revenue. The best evidence of standalone selling price is the observable price of a good or service when the entity sells that good or service separately. The residual approach is different from the residual method that is used currently by some entities, such as software companies. Step two requires the identification of the separate performance obligations in the contract.

However, the Financial Accounting Standards Board (FASB) and  International Accounting Standards Board (IASB) released ASC 606 to standardize revenue recognition processes. Generally Accepted Accounting Principles (GAAP) represent the set of standardized rules, principles, and practices for recording and reporting financial information. It was established to improve uniformity, comparability, and clarity of financial information.

This means Company D should recognize their client revenue in January, even though the cash for those services wasn’t received until April. The most important thing to realize here, particularly for SaaS companies, is that cash isn’t revenue. We explain the difference in more detail in this post, but in general, no matter when a customer’s cash arrives in your bank account, 5 steps in revenue recognition process you don’t count it as revenue until you have delivered the product or service that it paid for. So how do you know when to record your revenue, then, if it’s different for every business? To help you out ​​with this financial reporting issue, we’ve put together some revenue recognition examples that show how revenue should be realized for businesses of all kinds.

On the other hand, SaaS transactions can often include performance obligations that seem distinct but are not actually separate. Say you’re upgrading a hospital’s computer network with custom software integrations that connect to existing systems, and the employees of the hospital will need training from your company to be able to use the software. Even though the design, installation, and training may seem like different deliverables, the hospital’s ability to use the new network is dependent on all three deliverables functioning together.

The final step of the revenue recognition process occurs when the goods are delivered or the services are rendered and control is handed over to the customer. The customer is considered to have control once they can benefit from the good or service. When a performance obligation has been satisfied, you can then recognize the revenue. The SEC also continues to focus on non-GAAP https://adprun.net/ metrics, including adjustments that change the accounting policy or the method of recognition of an accounting measure that may be misleading and, therefore, impermissible. For more information, see Deloitte’s Roadmap Non-GAAP Financial Measures and Metrics. Under the new standards, you should recognize the revenue on the books when the customer receives the goods or service.