07. Revenue Recognition: Core Principles and Applications

By Jay

What is a Contract?

Under ASC 606, a contract is an agreement between two or more parties that creates enforceable rights and obligations.

Contracts may be written, oral, or implied by customary business practices. The assessment of whether a contract exists must be performed at the inception of the revenue arrangement.

Criteria for a Valid Contract (ASC 606-10-25-1)

A contract exists for revenue recognition purposes only when all of the following criteria are met:

  1. Approval and Commitment
    The contract has been approved by all parties involved, and each party is committed to fulfilling their respective obligations.

  2. Identifiable Rights
    The rights of each party regarding the goods or services to be transferred are clearly identifiable.

  3. Identifiable Payment Terms
    The payment terms for the goods or services to be transferred are clear and specific.

  4. Commercial Substance
    The contract has commercial substance, meaning that the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract.

  5. Probable Collection
    It is probable that the entity will collect the consideration to which it is entitled in exchange for the goods or services transferred.

🔎 "Probable" means “likely to occur” under US GAAP, generally interpreted as a likelihood of more than 75%.

USCPA Exam Tip

  • Even if a customer agrees to buy a product, revenue cannot be recognized unless all five criteria are met.
  • If any condition is not met, the contract is not accounted for under ASC 606 until reassessed.

🔑 Key Concept: 5-Step Model: I am a STAR

ASC 606 provides a unified model for recognizing revenue from contracts with customers.

✅ Step 1: Identify the Contract

  • A contract is an agreement between two or more parties that creates enforceable rights and obligations.
  • Criteria include: approval, identification of rights and payment terms, commercial substance, and collectibility.
  • Revenue when job is done

✅ Step 2: Identify the Seperate Performance Obligations

  • A performance obligation is a promise to transfer a distinct good or service.
  • If goods/services are not distinct, they are combined.

✅ Step 3: Determine the Transaction Price

  • Consider variable consideration, time value of money, noncash consideration, and consideration payable to the customer.

✅ Step 4: Allocate the Transaction Price

  • Allocate based on standalone selling prices of each performance obligation.

✅ Step 5: Recognize Revenue

  • Revenue is recognized when (or as) the performance obligation is satisfied.
  • Over time (e.g., services), or at a point in time (e.g., product delivery).

🧾 Common Journal Entries

At contract inception (no entry unless cash is received)

Dr. Cash or A/R  
   Cr. Unearned Revenue (if received before delivery)

When revenue is recognized

Dr. Unearned Revenue (if deferred)  
Dr. Cash or A/R (if not yet received)  
   Cr. Revenue

More info for Step 3: Transaction Price

1. Variable consideration

Under ASC 606, variable consideration is part of the transaction price that depends on future events. These may include discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items.

The entity must estimate variable consideration using one of two methods:

Methods to Estimate Variable Consideration

MethodDescriptionWhen to Use
Expected ValueWeighted average of possible outcomes, based on probabilities.Appropriate when there are a large number of similar contracts.
Most Likely AmountSingle most likely amount in a range of possible outcomes.Suitable when only a few outcomes are likely (e.g., all-or-nothing bonus).

🔹 The entity must apply the chosen method consistently to similar contracts with similar characteristics.

Constraint on Variable Consideration

Variable consideration is only included in the transaction price to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty is resolved.

This is known as the “constraint” principle.

Factors to consider when assessing the likelihood of a significant revenue reversal:

  • Poor historical performance or forecasting
  • Dependency on external factors (e.g., weather, market volatility)
  • High variability in outcomes
  • Lack of experience with similar contracts

Example

A software company agrees to receive a $50,000 base price for licensing, plus a $10,000 performance bonus if the customer installs the software by a specific date. The company estimates a 70% probability of success.

  • Using expected value:
    • $10,000 × 70% = $7,000 → include in transaction price if reversal not probable
  • Using most likely amount:
    • Since 70% chance of success, most likely amount = $10,000

If company concludes that including $10,000 will not lead to significant reversal → include full amount.

Journal Entry (Assuming revenue recognized upfront):

Dr. Accounts Receivable     $60,000
   Cr. Revenue                     $60,000
(Assumes $50,000 base + $10,000 bonus included because reversal not probable.)

2. Time Value of Money
If the timing of payments agreed to by the parties to the contract provides a significant benefit of financing to either the customer or the entity, the transaction price should reflect the time value of money.

  • Adjustments are made if payment is significantly deferred or paid in advance.
  • A discount rate (reflecting the customer's credit risk) is used to separate the revenue component from the interest.
  • No adjustment is needed if the time between payment and performance is less than one year (practical expedient).

📌 Example:
A company agrees to deliver goods today but receive payment after 2 years. The payment must be discounted to present value and the difference recognized as interest income.

3. Non-Cash Consideration
If the customer pays with goods, services, or other non-cash items instead of cash, the entity should measure the transaction price at the fair value of the non-cash consideration at contract inception.

  • If the fair value cannot be reasonably estimated, refer to the standalone selling price of the promised goods or services.

📌 Example:
A customer gives a machine instead of cash in exchange for software services. The value of the machine (its fair market value) is used to determine transaction price.

4. Consideration Paid or Payable to the Customer
Any consideration that the entity pays, or expects to pay, to a customer should be accounted for as a reduction of the transaction price, unless the payment is in exchange for a distinct good or service from the customer.

  • Includes: cash, credits, coupons, rebates, or free products.
  • If payment is for a separate good/service, account for it as an expense.

📌 Example:
A company offers a $50 rebate after the customer buys a product. The $50 reduces the transaction price unless the rebate is for something separate (e.g., advertising services provided by the customer).

More info for Step 4: Allocate to the transaction price

Once the total transaction price has been determined, it must be allocated to each performance obligation in the contract based on relative standalone selling prices (SSP).

🔹 Identify Standalone Selling Prices (SSPs)

  • Definition: The price at which an entity would sell a promised good or service separately to a customer.
  • Use observable prices if available.
  • If SSPs are not directly observable, estimate them using suitable methods (see below).

🔹 Estimation Methods for SSP in order of preference
1. Adjusted Market Assessment Approach

  • Evaluate the market and estimate the price customers would be willing to pay.
  • Consider competitors’ prices and adjust for entity-specific factors.

2. Expected Cost Plus a Margin Approach

  • Estimate the expected cost of satisfying the obligation and add a reasonable margin.

3. Residual Approach

  • Use when SSP is highly variable or uncertain.
  • Subtract observable SSPs of other goods/services in the contract from the total transaction price.

🔹 Allocation Based on Relative SSPs

Allocated Price=(Standalone Selling Price of ObligationTotal of all SSPs)×Transaction Price\text{Allocated Price} = \left( \frac{\text{Standalone Selling Price of Obligation}}{\text{Total of all SSPs}} \right) \times \text{Transaction Price}

📌 Example:
A contract includes two deliverables:

  • Product A (SSP: $600)
  • Product B (SSP: $400)
    Total transaction price = $900
    Allocation:
    - Product A: 6001000×900=540\frac{600}{1000} \times 900 = 540
    - Product B: 4001000×900=360\frac{400}{1000} \times 900 = 360

🔹 Special Considerations

  • Discounts: Allocate proportionally unless the discount is specifically tied to a single performance obligation.
  • Variable Consideration: Allocate to one or more performance obligations only if:
    • Terms relate specifically to that obligation, and
    • Allocation reflects the amount expected as consideration.

✅ Key Point: Allocation must be systematic, rational, and reflect the economics of the transaction.

More info for Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation

Revenue is recognized when control of the good or service is transferred to the customer, either over time or at a point in time.

🔹 Over Time vs. Point in Time

1. Revenue Recognized Over Time
Revenue is recognized progressively if any of the following conditions are met:

  • The customer simultaneously receives and consumes the benefits (e.g., cleaning services).
  • The entity’s performance creates or enhances an asset that the customer controls (e.g., building a facility on the customer’s land).
  • The asset has no alternative use to the entity, and the entity has a right to payment for performance to date (e.g., custom software development).

Progress Measurement Methods:

  • Output methods: e.g., milestones reached, units delivered.
  • Input methods: e.g., costs incurred, labor hours.

📌 Note: Use methods that best depict performance and faithfully represent progress.

2. Revenue Recognized at a Point in Time
Revenue is recognized when control passes to the customer. Indicators include:

  • Right to payment
  • Legal title transfer
  • Physical possession
  • Customer acceptance
  • Risks and rewards transferred

📌 Example: A company delivers a product to the customer. If the customer has accepted delivery and has title, control is likely transferred.

🔹 Performance Obligation Satisfied = Recognize Revenue
Each distinct good or service in the contract must be evaluated separately for revenue recognition.

🔹 Contract Modifications
If a contract is modified, reassess:

  • Performance obligations
  • Pricing
  • Timing of revenue recognition

✅ Key Point: The timing of revenue recognition depends on when control is transferred, not when payment is received.

🧠 Notes

  • Incremental costs of obtaining a contract (e.g., sales commissions) are capitalized if expected to be recovered.
  • Contract asset: performance obligation is satisfied, but not yet billed.
  • Contract liability: customer pays in advance, but goods/services not delivered yet.

🔍 Practice Questions

Q1:

A company enters into a contract to sell 1,000 units of a product for $10 each. The product is delivered over 5 months. How much revenue is recognized each month?

Answer: $2,000 per month
Explanation: $10,000 total / 5 months = $2,000 per month (assuming equal delivery and satisfaction of performance obligations).

Q2:

A company receives $12,000 in advance for a 12-month subscription service. What is the journal entry after receiving cash, and then after one month?

Initial Entry:

Dr. Cash $12,000  
   Cr. Unearned Revenue $12,000

After One Month:

Dr. Unearned Revenue $1,000  
   Cr. Revenue $1,000