The Revenue Recognition Principle and Recent Changes
Understanding the difference between revenue and income is essential to understanding revenue recognition:
- Revenue is defined as the total amount of money a business receives from its customers. Revenue is the first line on the company’s income statement.
- Income (or net income) refers to the company’s net profit (i.e., the amount that is left after expenses and taxes are subtracted from revenue). Income is the last line — the bottom line — on the company’s income statement.
The Revenue Recognition Principle
The revenue recognition principle is more complicated. It sets a standard that requires revenue to be recorded when it is earned rather than when it is received. Requiring all company financial statements to use the same formula for reporting revenue is intended to provide a certain level of comparability between companies.
Accounting Standards Codification 606 Made Fundamental Changes
In practice, the principle requires that a revenue-generating activity must be completed or effectively completed in the same accounting period that payment is received or is expected to be received. Accounting Standards Codification (ASC) 606, which was enacted in 2014, fundamentally changed how it is applied. ASC 606 became effective for public companies in 2018 and for privately held companies in 2019. Previously, the reporting standard varied according to industry. Now, under ASC 606, the standard is industry neutral, making it more transparent.
ASC 606 applies to all contracts with customers, except for leases, insurance contracts, financial instruments, guarantees and certain nonmonetary exchanges between entities in the same line of business. There are two approaches that each company needs to consider:
- The full retrospective approach requires an entity to restate all prior periods presented in the financial statements as if the period had originally been accounted for using ASC Topic 606. A cumulative adjustment would be made to necessary balance sheet accounts and the opening balance of retained earnings as of January 1, 2018, and all comparative periods would be restated.
- The modified retrospective approach allows for a slightly simpler implementation. The entity would only apply the new revenue recognition standard to contracts that are in process as of December 31, 2018 and onward. The cumulative adjustment would be reflected in the opening balance sheet at January 2019 as a change to the prior periods retained earnings and disclosed in the financial statements. Comparative periods would not need to be restated.
Five Steps to Determining When Revenue Is Recognized
Use the following five steps to determine when revenue is recognized:
- Identify the contract
- Identify the contractual performance obligations
- Determine the amount of consideration/price for the transaction
- Allocate the determined amount of consideration or price to the contractual obligations
- Recognize revenue when or as the performing party satisfies performance obligations
This may sound simple, but following ASC 606 may require adjustments to a company’s policies, processes, and systems. Segmenting each performance obligation and its associated costs can be quite difficult and time-consuming.
Entities should carefully consider each method of adoption and the impact it could have on its financial position while taking into consideration the concerns of sureties, bankers, and other users of the ﬁnancial statements.
If you have any questions or would like more information on Topic 606, Revenue from Contracts with Customers please contact Sean T. Daughton, CPA, CFE at (315)472-9127 or email email@example.com.