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1.2.11.1.2 Revenue recognition steps
Achievable CMA Part 1
1. Financial transactions
1.2. Income statement
1.2.11. Revenue recognition
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Revenue recognition steps

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Definitions
Revenues
According to ASC 606, these are “inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.”

The core principle of revenue recognition is for an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

The application of this core principle is further reflected in the five-step model:

  1. Step 1 - Identify the contract
  2. Step 2 - Identify the performance obligations
  3. Step 3 - Determine the transaction price
  4. Step 4 - Allocate the transaction price to the performance obligations
  5. Step 5 - Recognize revenue as the performance obligations are satisfied
Five-step flowchart illustrating revenue recognition from identifying a contract to recognizing revenue as obligations are satisfied.
Revenue Recognition Steps
Achievable

Step 1 - Identify the contract

The first step in applying the revenue standard is to determine if the contract is within the scope of the ASC 606 as a contract with a customer.

This assessment is done on a contract-by-contract basis. Since certain arrangements are specifically covered by other standards, Step 1 involves an assessment of whether the arrangement is covered by another guidance, and therefore excluded from ASC 606. Examples of contracts covered by other standards include leases (ASC 842), insurance contracts (ASC 944), certain financial instruments, nonmonetary exchanges between entities in the same line of business, and guarantees (ASC 460).

When it is confirmed that the arrangement is not covered by another guidance, the company should then assess if it falls within the definition of a contract with a customer by satisfying all of the criteria below:

  1. The contract has been approved whether in writing, orally, or with customary business practices, and the parties are committed to perform their obligations
  2. The company can identify each party’s rights regarding the goods or services to be transferred
  3. The company can identify the payment terms in exchange for the goods or services to be transferred
  4. The contract has commercial substance, which means the risk, timing, or amount of the company’s future cash flows is expected to change as a result of the contract
  5. It is probable that the company will be able to collect substantially all of the consideration it is entitled to based on the contract

The criteria above determine whether there are enforceable rights and obligations in a contract. If any criterion is not met, the arrangement is not a contract with a customer under ASC 606, so the company does not apply the five-step model to it and keeps reassessing the criteria.

GAAP vs. IFRS insight: ASC 606 and IFRS 15 are largely converged, but they set the “probable” collectability threshold in criterion 5 differently. Under ASC 606, “probable” means likely to occur (a relatively high bar), while IFRS 15 uses “more likely than not” (just above 50%). An arrangement that clears the IFRS 15 threshold can still fail the US GAAP one. The rest of this chapter follows the US GAAP treatment.

Step 2 - Identify the performance obligations

After confirming from Step 1 that the arrangement is a contract with a customer within the scope of the revenue guidance, we need to examine the contract for the promised goods and services and to identify which of them are separate performance obligations.

Revenues are recognized based on performance obligations and it is important to identify them because when a contract has multiple performance obligations in exchange for a single consideration, the performance obligations become the unit of account for which we split the consideration to recognize the revenues.

Definitions
Performance obligation
This is a promise in the contract made by the company to transfer to the customer:
  • A distinct good or service; or
  • A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

A contract may contain multiple promises and the revenue standard has provided some guidance to determine which provisions are considered distinct promises to the customer by answering a few questions:

  • Can the customer benefit from the good or service on its own or with other readily available resources?
  • Is the entity’s promise to transfer the good or service separately identifiable from other promises in the contract?

If the answer to any of the questions above is “no”, then the promise is not distinct. The company should group it with other promises within the contract until a distinct bundle is identified as a separate performance obligation.

Step 3 - Determine the transaction price

After identifying the performance obligations in Step 2, we need to determine the total consideration that needs to be split later (in Step 4) for these performance obligations. This consideration is referred to as the transaction price.

Definitions
Transaction price
This is the amount of consideration an entity is expecting to be entitled in exchange for the goods or services being transferred to the customer.

The process can be a straightforward exercise since in most simple cases, the transaction price is specifically identified in the contract. However, it can be complicated when variable considerations and financing components are concerned.

The table below summarizes the most common items to be included in the transaction price.

Fixed consideration XX
Variable consideration XX
Significant financing component (XX) or XX
Non-cash component XX
Total transaction price XX

The components of the consideration aside from the fixed component are discussed below.

Variable consideration

This arises in a contract in which the amount of consideration that the entity is expected to be entitled to is not fixed.

This could be because of provisions in the contract that depend on some future milestone such as incentives and bonuses to the company; or provisions that reduce the consideration for any reasons such as customer dissatisfaction, as in the case for rebates, refunds, and penalties.

An entity is required to estimate the amount of variable consideration by using either of two methods:

  1. The expected value method - The sum of probability-weighted amounts in a range of possible consideration amounts which may be appropriate if the contract has large number of possible outcomes; or
  2. The most likely amount method - The single most likely amount in a range of possible consideration amounts which may be appropriate if the contract has a few possible outcomes (i.e., when outcomes are meeting the milestone or not).

Once the estimate has been computed, the company should apply the “variable consideration constraint” by recognizing (i.e., only including in the transaction price) an amount that reflects the extent it is probable that a significant reversal in the amount of revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved.

At the end of each accounting period, the company must re-assess the estimated transaction price for any changes in circumstances.

Significant financing component

A contract contains a significant financing component when the timing of payments (in advance or in arrears) gives the customer or the entity a significant benefit of financing. As a practical expedient, no adjustment is needed if the period between transfer of the good or service and payment is one year or less.

In this case, the amount included in the transaction price is the total of the future payments adjusted for the time value of money. The amount included in the transaction price is recognized as revenue when the performance obligations are fulfilled, while the difference between the total consideration and the discounted future payments is recognized as interest income (deferred payment) or interest expense (advance payment) over time. This approach fulfills the objective of recognizing revenues on the contract at an amount that reflects the cash selling price of the good or service.

The payments are discounted at a discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. This discount rate is not updated for any change in circumstances.

Non-cash consideration

When the contract with the customer involves a non-cash consideration, the company should measure the non-cash consideration at fair value at the inception of the contract (i.e., when the criteria for contract existence are met in Step 1).

The fair value of the non-cash consideration becomes part of the transaction price. However, when the fair value cannot be reasonably estimated, the non-cash consideration can be indirectly measured by the stand-alone selling price of the goods or service promised to the customer in the contract.

Non-cash considerations could be in the form of inventories, stocks or warrants, PPE, or other types of assets.

Step 4 - Allocate the transaction price to the performance obligations

After determining the transaction price in Step 3, the next step is to allocate this amount to the individual performance obligations identified in Step 2.

The transaction price is allocated based on the relative standalone selling prices (SSP) of the performance obligations.

Definitions
Standalone selling prices (SSP)
According to ASC 606-10, the SSP is the price at which an entity would sell a promised good or service separately to a customer.

When SSPs are available for all performance obligations, the company simply allocates the transaction price on a prorata basis using the SSPs then proceeds to Step 5 for the recognition of the revenues. If the standalone selling price is not directly observable, then it must be estimated.

The best evidence of SSP is the observable price when the entity sells the item separately to similar customers. If that isn’t available, estimate SSP using (1) the adjusted market assessment approach, (2) the expected cost plus a margin approach, or (3) the residual approach. The residual approach is allowed only when the SSP is highly variable or uncertain.

It’s important to remember that we determine the standalone selling price of each item in a contract at inception. Even if the price changes later on, we don’t go back and adjust the original allocation performed in this step.

In the case of a discount, the company has to determine if the discount pertains to one or more individual performance obligations and allocate the discount proportionately to those performance obligations only. If there is no evidence that the discount pertains to specific performance obligations, then the discount is allocated to all performance obligations proportionately using the SSPs. This could be the case when companies typically sell products in bundles.

Example: Allocating a bundle price

A company sells equipment with a standalone selling price of $80,000 bundled with one year of installation services with a standalone selling price of $20,000. The combined contract price is $90,000 (a $10,000 discount off the $100,000 combined SSP), and there’s no evidence the discount relates to just one of the two items, so it’s allocated proportionately.

  • Total SSP: $80,000 + $20,000 = $100,000
  • Equipment’s share: $80,000 divided by $100,000, times $90,000, equals $72,000
  • Service’s share: $20,000 divided by $100,000, times $90,000, equals $18,000

The equipment is a single promise satisfied at a point in time (when control transfers), so the company recognizes its $72,000 allocation at delivery. The installation service is performed over the contract period, so the company recognizes its $18,000 allocation over time as the service is performed.

Answer: $72,000 to the equipment (point in time); $18,000 to the service (over time)

Step 5 - Recognize revenue as the performance obligations are satisfied

The last step of revenue recognition follows after the company has determined the share of each individual performance obligation of the transaction price.

The main concept of Step 5 is the determination of when the performance obligation is satisfied because it triggers the recognition of the revenue allocated to that performance obligation.

A company satisfies its performance obligation to the customer by transferring control of the goods or service related to the performance obligation which could be done in two cases:

  1. Performance obligations are satisfied over time
  2. Performance obligations are satisfied at a point in time

Case 1: Performance obligations satisfied over time

This means the revenue allocated is recognized based on a measure of progress determined by the entity. The performance obligation is satisfied over time when one of the following criteria is met:

  1. There is simultaneous receipt and consumption of the benefits provided by the company’s performance of the obligations from the contract
  2. The company’s performance of the obligations from the contract enhances or creates an asset controlled by the customer
  3. The company’s performance of the obligations from the contract does not create an asset with an alternative use to the company, and the company has an enforceable right to payment for performance completed to date.

Case 2: Performance obligations satisfied at a point in time

This means the whole revenue allocated to the performance obligations is recognized at once, when the performance obligation (i.e., the promise to the customer) is satisfied.

If a performance obligation is not satisfied over time based on the three criteria identified above, then the performance obligation is satisfied at a point in time.

Generally, the customer obtains control of the asset when they have:

  1. The ability to direct the use of the asset; and
  2. The ability to obtain substantially all of the remaining benefits from the asset.

Revenue Recognition Core Principle

  • Recognize revenue to depict transfer of goods/services at amount entity expects to be entitled to
  • Five-step model: identify contract → identify performance obligations → determine transaction price → allocate transaction price → recognize revenue

Step 1: Identify the Contract

  • Must verify arrangement isn’t covered by other GAAP (leases, insurance, certain financial instruments, guarantees)
  • All 5 criteria must be met: approval/commitment, identifiable rights, identifiable payment terms, commercial substance, probable collectability
  • GAAP “probable” (likely) is stricter than IFRS 15 “more likely than not” (>50%)

Step 2: Identify Performance Obligations

  • Performance obligation = promise to transfer a distinct good/service or series of substantially same distinct goods/services
  • Distinct test: customer can benefit from it alone/with readily available resources, AND it’s separately identifiable from other contract promises
  • If not distinct, bundle with other promises until a distinct unit emerges

Step 3: Determine Transaction Price

  • Transaction price = fixed + variable consideration +/- financing component + non-cash consideration
  • Variable consideration estimated via expected value method (probability-weighted) or most likely amount method (single most likely outcome); subject to constraint (only include if significant reversal unlikely); reassessed each period
  • Significant financing component: adjust for time value of money unless payment timing ≤1 year (practical expedient); discount rate set at inception, not updated
  • Non-cash consideration measured at fair value at contract inception; if unknown, use stand-alone selling price

Step 4: Allocate Transaction Price

  • Allocate based on relative standalone selling prices (SSP) of each performance obligation
  • Best evidence = observable separate selling price; otherwise estimate via adjusted market assessment, expected cost-plus-margin, or residual approach (residual only if SSP highly variable/uncertain)
  • SSP determined at contract inception and not adjusted later
  • Discounts allocated proportionately to all obligations unless evidence ties discount to specific obligation(s)

Step 5: Recognize Revenue

  • Revenue recognized when performance obligation satisfied via transfer of control, either over time or at a point in time
  • Satisfied over time if: simultaneous receipt/consumption, performance creates/enhances customer-controlled asset, or no alternative use to entity + enforceable right to payment for work completed
  • If none of these apply, satisfied at a point in time (when customer gains ability to direct use and obtain substantially all remaining benefits)

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Revenue recognition steps

Definitions
Revenues
According to ASC 606, these are “inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.”

The core principle of revenue recognition is for an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

The application of this core principle is further reflected in the five-step model:

  1. Step 1 - Identify the contract
  2. Step 2 - Identify the performance obligations
  3. Step 3 - Determine the transaction price
  4. Step 4 - Allocate the transaction price to the performance obligations
  5. Step 5 - Recognize revenue as the performance obligations are satisfied

Step 1 - Identify the contract

The first step in applying the revenue standard is to determine if the contract is within the scope of the ASC 606 as a contract with a customer.

This assessment is done on a contract-by-contract basis. Since certain arrangements are specifically covered by other standards, Step 1 involves an assessment of whether the arrangement is covered by another guidance, and therefore excluded from ASC 606. Examples of contracts covered by other standards include leases (ASC 842), insurance contracts (ASC 944), certain financial instruments, nonmonetary exchanges between entities in the same line of business, and guarantees (ASC 460).

When it is confirmed that the arrangement is not covered by another guidance, the company should then assess if it falls within the definition of a contract with a customer by satisfying all of the criteria below:

  1. The contract has been approved whether in writing, orally, or with customary business practices, and the parties are committed to perform their obligations
  2. The company can identify each party’s rights regarding the goods or services to be transferred
  3. The company can identify the payment terms in exchange for the goods or services to be transferred
  4. The contract has commercial substance, which means the risk, timing, or amount of the company’s future cash flows is expected to change as a result of the contract
  5. It is probable that the company will be able to collect substantially all of the consideration it is entitled to based on the contract

The criteria above determine whether there are enforceable rights and obligations in a contract. If any criterion is not met, the arrangement is not a contract with a customer under ASC 606, so the company does not apply the five-step model to it and keeps reassessing the criteria.

GAAP vs. IFRS insight: ASC 606 and IFRS 15 are largely converged, but they set the “probable” collectability threshold in criterion 5 differently. Under ASC 606, “probable” means likely to occur (a relatively high bar), while IFRS 15 uses “more likely than not” (just above 50%). An arrangement that clears the IFRS 15 threshold can still fail the US GAAP one. The rest of this chapter follows the US GAAP treatment.

Step 2 - Identify the performance obligations

After confirming from Step 1 that the arrangement is a contract with a customer within the scope of the revenue guidance, we need to examine the contract for the promised goods and services and to identify which of them are separate performance obligations.

Revenues are recognized based on performance obligations and it is important to identify them because when a contract has multiple performance obligations in exchange for a single consideration, the performance obligations become the unit of account for which we split the consideration to recognize the revenues.

Definitions
Performance obligation
This is a promise in the contract made by the company to transfer to the customer:
  • A distinct good or service; or
  • A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

A contract may contain multiple promises and the revenue standard has provided some guidance to determine which provisions are considered distinct promises to the customer by answering a few questions:

  • Can the customer benefit from the good or service on its own or with other readily available resources?
  • Is the entity’s promise to transfer the good or service separately identifiable from other promises in the contract?

If the answer to any of the questions above is “no”, then the promise is not distinct. The company should group it with other promises within the contract until a distinct bundle is identified as a separate performance obligation.

Step 3 - Determine the transaction price

After identifying the performance obligations in Step 2, we need to determine the total consideration that needs to be split later (in Step 4) for these performance obligations. This consideration is referred to as the transaction price.

Definitions
Transaction price
This is the amount of consideration an entity is expecting to be entitled in exchange for the goods or services being transferred to the customer.

The process can be a straightforward exercise since in most simple cases, the transaction price is specifically identified in the contract. However, it can be complicated when variable considerations and financing components are concerned.

The table below summarizes the most common items to be included in the transaction price.

Fixed consideration XX
Variable consideration XX
Significant financing component (XX) or XX
Non-cash component XX
Total transaction price XX

The components of the consideration aside from the fixed component are discussed below.

Variable consideration

This arises in a contract in which the amount of consideration that the entity is expected to be entitled to is not fixed.

This could be because of provisions in the contract that depend on some future milestone such as incentives and bonuses to the company; or provisions that reduce the consideration for any reasons such as customer dissatisfaction, as in the case for rebates, refunds, and penalties.

An entity is required to estimate the amount of variable consideration by using either of two methods:

  1. The expected value method - The sum of probability-weighted amounts in a range of possible consideration amounts which may be appropriate if the contract has large number of possible outcomes; or
  2. The most likely amount method - The single most likely amount in a range of possible consideration amounts which may be appropriate if the contract has a few possible outcomes (i.e., when outcomes are meeting the milestone or not).

Once the estimate has been computed, the company should apply the “variable consideration constraint” by recognizing (i.e., only including in the transaction price) an amount that reflects the extent it is probable that a significant reversal in the amount of revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved.

At the end of each accounting period, the company must re-assess the estimated transaction price for any changes in circumstances.

Significant financing component

A contract contains a significant financing component when the timing of payments (in advance or in arrears) gives the customer or the entity a significant benefit of financing. As a practical expedient, no adjustment is needed if the period between transfer of the good or service and payment is one year or less.

In this case, the amount included in the transaction price is the total of the future payments adjusted for the time value of money. The amount included in the transaction price is recognized as revenue when the performance obligations are fulfilled, while the difference between the total consideration and the discounted future payments is recognized as interest income (deferred payment) or interest expense (advance payment) over time. This approach fulfills the objective of recognizing revenues on the contract at an amount that reflects the cash selling price of the good or service.

The payments are discounted at a discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. This discount rate is not updated for any change in circumstances.

Non-cash consideration

When the contract with the customer involves a non-cash consideration, the company should measure the non-cash consideration at fair value at the inception of the contract (i.e., when the criteria for contract existence are met in Step 1).

The fair value of the non-cash consideration becomes part of the transaction price. However, when the fair value cannot be reasonably estimated, the non-cash consideration can be indirectly measured by the stand-alone selling price of the goods or service promised to the customer in the contract.

Non-cash considerations could be in the form of inventories, stocks or warrants, PPE, or other types of assets.

Step 4 - Allocate the transaction price to the performance obligations

After determining the transaction price in Step 3, the next step is to allocate this amount to the individual performance obligations identified in Step 2.

The transaction price is allocated based on the relative standalone selling prices (SSP) of the performance obligations.

Definitions
Standalone selling prices (SSP)
According to ASC 606-10, the SSP is the price at which an entity would sell a promised good or service separately to a customer.

When SSPs are available for all performance obligations, the company simply allocates the transaction price on a prorata basis using the SSPs then proceeds to Step 5 for the recognition of the revenues. If the standalone selling price is not directly observable, then it must be estimated.

The best evidence of SSP is the observable price when the entity sells the item separately to similar customers. If that isn’t available, estimate SSP using (1) the adjusted market assessment approach, (2) the expected cost plus a margin approach, or (3) the residual approach. The residual approach is allowed only when the SSP is highly variable or uncertain.

It’s important to remember that we determine the standalone selling price of each item in a contract at inception. Even if the price changes later on, we don’t go back and adjust the original allocation performed in this step.

In the case of a discount, the company has to determine if the discount pertains to one or more individual performance obligations and allocate the discount proportionately to those performance obligations only. If there is no evidence that the discount pertains to specific performance obligations, then the discount is allocated to all performance obligations proportionately using the SSPs. This could be the case when companies typically sell products in bundles.

Example: Allocating a bundle price

A company sells equipment with a standalone selling price of $80,000 bundled with one year of installation services with a standalone selling price of $20,000. The combined contract price is $90,000 (a $10,000 discount off the $100,000 combined SSP), and there’s no evidence the discount relates to just one of the two items, so it’s allocated proportionately.

  • Total SSP: $80,000 + $20,000 = $100,000
  • Equipment’s share: $80,000 divided by $100,000, times $90,000, equals $72,000
  • Service’s share: $20,000 divided by $100,000, times $90,000, equals $18,000

The equipment is a single promise satisfied at a point in time (when control transfers), so the company recognizes its $72,000 allocation at delivery. The installation service is performed over the contract period, so the company recognizes its $18,000 allocation over time as the service is performed.

Answer: $72,000 to the equipment (point in time); $18,000 to the service (over time)

Step 5 - Recognize revenue as the performance obligations are satisfied

The last step of revenue recognition follows after the company has determined the share of each individual performance obligation of the transaction price.

The main concept of Step 5 is the determination of when the performance obligation is satisfied because it triggers the recognition of the revenue allocated to that performance obligation.

A company satisfies its performance obligation to the customer by transferring control of the goods or service related to the performance obligation which could be done in two cases:

  1. Performance obligations are satisfied over time
  2. Performance obligations are satisfied at a point in time

Case 1: Performance obligations satisfied over time

This means the revenue allocated is recognized based on a measure of progress determined by the entity. The performance obligation is satisfied over time when one of the following criteria is met:

  1. There is simultaneous receipt and consumption of the benefits provided by the company’s performance of the obligations from the contract
  2. The company’s performance of the obligations from the contract enhances or creates an asset controlled by the customer
  3. The company’s performance of the obligations from the contract does not create an asset with an alternative use to the company, and the company has an enforceable right to payment for performance completed to date.

Case 2: Performance obligations satisfied at a point in time

This means the whole revenue allocated to the performance obligations is recognized at once, when the performance obligation (i.e., the promise to the customer) is satisfied.

If a performance obligation is not satisfied over time based on the three criteria identified above, then the performance obligation is satisfied at a point in time.

Generally, the customer obtains control of the asset when they have:

  1. The ability to direct the use of the asset; and
  2. The ability to obtain substantially all of the remaining benefits from the asset.
Key points

Revenue Recognition Core Principle

  • Recognize revenue to depict transfer of goods/services at amount entity expects to be entitled to
  • Five-step model: identify contract → identify performance obligations → determine transaction price → allocate transaction price → recognize revenue

Step 1: Identify the Contract

  • Must verify arrangement isn’t covered by other GAAP (leases, insurance, certain financial instruments, guarantees)
  • All 5 criteria must be met: approval/commitment, identifiable rights, identifiable payment terms, commercial substance, probable collectability
  • GAAP “probable” (likely) is stricter than IFRS 15 “more likely than not” (>50%)

Step 2: Identify Performance Obligations

  • Performance obligation = promise to transfer a distinct good/service or series of substantially same distinct goods/services
  • Distinct test: customer can benefit from it alone/with readily available resources, AND it’s separately identifiable from other contract promises
  • If not distinct, bundle with other promises until a distinct unit emerges

Step 3: Determine Transaction Price

  • Transaction price = fixed + variable consideration +/- financing component + non-cash consideration
  • Variable consideration estimated via expected value method (probability-weighted) or most likely amount method (single most likely outcome); subject to constraint (only include if significant reversal unlikely); reassessed each period
  • Significant financing component: adjust for time value of money unless payment timing ≤1 year (practical expedient); discount rate set at inception, not updated
  • Non-cash consideration measured at fair value at contract inception; if unknown, use stand-alone selling price

Step 4: Allocate Transaction Price

  • Allocate based on relative standalone selling prices (SSP) of each performance obligation
  • Best evidence = observable separate selling price; otherwise estimate via adjusted market assessment, expected cost-plus-margin, or residual approach (residual only if SSP highly variable/uncertain)
  • SSP determined at contract inception and not adjusted later
  • Discounts allocated proportionately to all obligations unless evidence ties discount to specific obligation(s)

Step 5: Recognize Revenue

  • Revenue recognized when performance obligation satisfied via transfer of control, either over time or at a point in time
  • Satisfied over time if: simultaneous receipt/consumption, performance creates/enhances customer-controlled asset, or no alternative use to entity + enforceable right to payment for work completed
  • If none of these apply, satisfied at a point in time (when customer gains ability to direct use and obtain substantially all remaining benefits)

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