The Five Step Model of Revenue Recognition
The new revenue recognition standards under ASC 606 are now in effect for all non-public companies. The new standard provides a five step model for recognizing revenue. The five steps are described below with items that companies should consider as they evaluate their revenue recognition.
Step 1 – Identify the contract with the customer
- Contracts can be written, oral, or implied, but must be enforceable.
- Contracts must have commercial substance i.e. the risk, timing, or amount of the company’s future cash flows will change as the result of the contract.
- It must be probable that the Company will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Step 2 – Identify the contractual performance obligations
- A performance obligation is a promise in a contract with a customer to transfer to the customer distinct goods or services.
- A good or service is district if it is separately identifiable from other promises in the contract.
- Consider each separate performance obligation in the contract. Each performance obligation should be separately identifiable from other obligations in the contract.
Step 3 – Determine the transaction price
- Consideration for the contract can be fixed or variable.
- Variable consideration is dependent on a future event.
- Can be in cash or in non-cash consideration.
Step 4 – Allocate the transaction price to the performance obligations in the contract
- For each identified performance obligation, a company has to allocate the contract consideration.
- Allocate the transaction price based on the observable price of each good or service, or an estimated selling price if the price is not readily observable.
Step 5 – Recognize revenue When (or as) Performance obligations are satisfied
- Recognize revenue individually for each performance obligation.
- An obligation is satisfied when a customer obtains control of the good or service.
- Control is either transferred at a point in time or over time.
- Revenue is therefore either recognized at a point in time or over time.