GAAP for Revenue Recognition: Criteria and Examples
Revenue is a financial measure of the goods and services that a company provides to its customers during a financial reporting period. It is said to be recognized when it is included in a company’s income statement. The GAAP for revenue recognition stipulates how and when revenue is to be recognized. It is the generally accepted accounting principle (GAAP) that determines how to account for revenue and specifies the conditions in which revenue is recognized.
The revenue recognition principle uses accrual accounting which requires that revenues are recognized when realized and earned; and not when cash is received. In this article, we will discuss the US GAAP for revenue recognition as well as ASC 606 which is the revenue recognition standard that provides a uniform framework for recognizing revenue from contracts with customers.
Related: Statement of Retained Earnings GAAP vs IFRS: Differences and Similarities
US GAAP revenue recognition Explained
Revenue significantly impacts the financial statement of a company and is a major factor in the overall financial performance of a company. Hence, revenue is considered recognized when it is included in a company’s income statement. Accounting for revenue on the income statement can be fairly straightforward when a product is sold and the revenue is recognized as the customer pays for the product. Nevertheless, revenue accounting can get complicated when a company takes a long time to deliver a product that has been paid for.
Analysts, therefore, prefer that the revenue recognition policies for one firm are also standard for the entire industry. Hence, having a standard revenue recognition guideline helps to ensure that an apples-to-apples comparison can be done between companies when reviewing line items on the profit & loss statement. In line with this, revenue recognition under GAAP is a feature of accrual accounting that requires revenue to be recognized on the income statement in the period that it is realized and earned; and not necessarily when the cash is received from the customer.
Hence, the US GAAP for revenue recognition is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which expenses and revenues are recognized. That is, according to the matching principle, revenue and its associated costs must be reported in the same accounting period.
Accounting Standards Codification (ASC) 606
ASC 606 is the revenue recognition standard that provides a uniform framework for recognizing revenue from contracts with customers. The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB), on May 28, 2014, issued converged guidance on recognizing revenue in contracts with customers. The guidance was issued as Accounting Standards Update (ASU) 2014-09 to replace numerous, industry-specific GAAP revenue recognition requirements. Hence, it is part of the Accounting Standards Codification (ASC) as Topic 606: Revenue from Contracts with Customers (ASC 606).
ASC 606 supersedes the old revenue recognition literature in Topic 605 issued by FASB (ASC 605). The old guidance was industry-specific, and as a result, created a system of fragmented policies while the updated revenue recognition standard tends to be more transparent being industry-neutral. It gives room for improved comparability of financial statements with standardized revenue recognition practices across multiple industries. The ASC 606 became effective for public entities for the first interim period within annual reporting periods that began after December 15, 2017, while non-public companies were allowed an additional year.
Conclusively, ASC 606 is a recent change in standardized accounting principles for revenue recognition. It covers revenue from contracts with customers and identifies performance and licensing obligations. The core principle of ASC 606 is 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
ASC 606
Hence, in order to achieve this core principle, companies and organizations must apply the following five steps to account for revenue earned from their business operations:
- Identify the contract with a customer
- Identify the performance obligations (promises) in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the reporting organization satisfies a performance obligation
Therefore, the primary difference between ASC 606 compared to 605 is that more comprehensive and detailed disclosures are required. For instance, companies will need to reveal separate revenue streams; if a contract liability was disclosed at the beginning of an accounting period and eventually becomes revenue at the end of the accounting period, the dots will need to be connected. In addition, in line with ASC 606, companies must now share qualitative data such as performance obligations which the ASC 605 did not require.
See also: Is accounts receivable an asset or revenue?
When to recognize revenue (GAAP)
Revenue recognition under GAAP is done in accordance with the revenue recognition principle. According to the US GAAP revenue recognition, revenues are recognized when they are realized and earned; this is usually when goods or services are delivered to customers regardless of when cash is received.
In business, cash can be received earlier or later than when goods or services are delivered. Hence, in accordance with the GAAP for revenue recognition, two types of accounts are used which are Accrued revenue (revenue is recognized before cash is received) and Deferred revenue (revenue is recognized as earned revenue as the goods or services are delivered). It is realizable and earned revenue that is then included as income during an accounting period.
The GAAP for revenue recognition requires that revenue is realizable when the goods or services have been received by the customer, but payment for the good or service is expected later. This is reported as accrued revenue. Deferred revenue, on the other hand, is a liability on a company’s statement of financial position. In order to follow GAAP guidelines for accounting conservatism, the deferred revenue account is used to represent a prepayment by customers for goods or services that are yet to be delivered. Deferred revenue is only recognized on the income statement as earned revenue when the good or service is delivered to the customer.
Related: Is Deferred Service Revenue a Debit or Credit?
When is revenue recognized under GAAP?
GAAP revenue recognition criteria
- Identify the contract with a customer
- Identify the performance obligations (promises) in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the reporting organization satisfies a performance obligation
A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. An agreement between two or more parties that creates enforceable rights and obligations is considered a contract. For GAAP revenue recognition criteria, a reporting company or organization will only recognize revenue when (or as) it transfers a promised good or service to a customer, which is when the customer acquires control of the good or service.
According to the GAAP revenue recognition criteria, the amount of revenue that is recognized is the amount allocated to the satisfied performance obligation (transferred good or service). In revenue recognition under GAAP, a performance obligation may be satisfied at a point in time (usually for promises to transfer goods to a customer) or over time (usually for promises to transfer services to a customer). For performance obligations satisfied over time, like in service-oriented companies, the reporting company should recognize revenue over time by selecting an appropriate method for measuring its progress toward the complete satisfaction of its promise to transfer services to a customer.
Read also: Unearned revenue examples and journal entries
GAAP for revenue recognition examples
Let’s look at some revenue recognition examples to show when to recognize revenue under GAAP. We will be using a retail company and a service provider company as an example to show how the GAAP revenue recognition criteria apply to the sale of goods and services respectively:
When to recognize revenue (GAAP) example 1
Assume, ABC Ltd is a retail company that sells appliances. The company has a lack of showroom space and as a result, customers usually purchase fridges, dishwashers, and other items without being able to accept the products on the spot. What they do is schedule delivery and installation for a later date.
Say, ABC Ltd sells a fridge and dishwasher to a customer on January 16th for $10,000 and the customer pays for the appliances on February 10th, but the goods aren’t delivered until March 3rd. Now, let’s see how this plays out in accordance with the GAAP for revenue recognition:
| Type | Description | Jan | Feb | Mar |
|---|---|---|---|---|
| Bookings | Amount customer committed to spend | $10,000 | – | – |
| Recognized Revenue | The revenue accrued for products delivered | – | – | $10,000 |
| Deferred Revenue | Revenue not yet earned with product still owed to the customer | $10,000 | $10,000 | – |
| Cash Collected | Actual cash collected from the customer and deposited into the bank | – | $10,000 | – |
Recall that according to the GAAP for revenue recognition, revenue is recognized when the purchased goods have been delivered to the customer. This means that ABC Ltd will recognize its revenue when the appliances are delivered to the customer, even if the customer paid for them in the weeks or months before delivery. Therefore, in this example, ABC Ltd will record the revenue in March because that is when the products were delivered even though the sale was booked in January and paid for in February.
When to recognize revenue (GAAP) example 2
Assume Company A is a service provider, a marketing firm that provides digital marketing solutions to growing startups. Let’s say the company provides $20,000 in marketing services to one of its clients in January, but the client doesn’t pay for those services until April. Now, let’s see how this plays out in accordance with the GAAP for revenue recognition:
| Type | Description | Jan | Feb | Mar | April |
|---|---|---|---|---|---|
| Bookings | Amount customer committed to spend | $20,000 | – | – | |
| Recognized Revenue | The revenue accrued for product delivered | $20,000 | – | – | |
| Deferred Revenue | Revenue not yet earned with product still owed to the customer | – | – | – | |
| Cash Collected | Actual cash collected from the customer and deposited into the bank | – | – | – | $20,000 |
Recall that according to the GAAP for revenue recognition, revenue is recognized when the purchased goods have been delivered to the customer regardless of when the cash is received. This means that even though the cash wasn’t collected until April, Company A recognizes revenue in January when the booking is made and the customer commits to spend.
The US GAAP revenue recognition for service-based businesses like consulting happens at the time of consulting (when revenue was realized and earned) even if the client pays at a later time. This is why Company A should recognize their service revenue in January, even though the cash for those services wasn’t received until April.
