The revenue recognition principle is the accounting rule that fixes which period revenue belongs to. A seller reports revenue in the period it satisfies its promise to the customer, not the period the customer’s money arrives. Work delivered in the last week of a quarter belongs to that quarter even where the bill and the payment both fall in the next one. Timing is what it settles. How much revenue a satisfied promise carries is a different question, answered by earlier steps of the same rule and worked through in sales revenue.
Where the Revenue Recognition Principle Lives Today
In US generally accepted accounting principles the rule sits in Topic 606, Revenue from Contracts with Customers, added to the Codification by Accounting Standards Update 2014-09. That Update replaced the guidance it found rather than joining it. The guidance in this Update supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance throughout the Industry Topics of the Codification (FASB, Accounting Standards Update 2014-09, Summary).
Older writing states the test as realized or realizable and earned. That wording came from Concepts Statement 5, and those recognition and measurement concepts were codified in Subtopic 605-10 (FASB, Accounting Standards Update 2014-09, Summary), which sits inside the Topic the Update superseded. So it describes the rule that was replaced, not the one in force. How a Codification reference like 606-10-05-4 reads is in ASC accounting.
The Five Steps
An entity recognizes revenue in accordance with the Topic’s core principle by applying five steps (FASB, Accounting Standards Update 2014-09, paragraph 606-10-05-4).
- Identify the contract with the customer, an agreement between two or more parties that creates enforceable rights and obligations.
- Identify the performance obligations in it, the promises to transfer goods or services that are distinct.
- Determine the transaction price, the consideration the entity expects to be entitled to in exchange for what it promised.
- Allocate the transaction price to the performance obligations, typically on the relative standalone selling prices of each distinct good or service.
- Recognize revenue when, or as, the entity satisfies a performance obligation, which is when the customer obtains control.
Only the last step is about timing. The first four settle what was promised and what the promise is worth, and the period falls out of them.
What the Principle Decides in a Firm’s Close
Inside a CPA firm it mostly settles what to do with work that is finished and not yet billed. Delivery is the event, so the close picks up delivered work rather than running off the invoice list, and a firm that bills in arrears ends most periods with earned fees no bill has gone out for. That amount is carried as an asset until it is invoiced, set out in accrued revenue, and a fee collected before the work is done runs the other way as a liability, set out in deferral and in unearned revenue is a liability account.
The book answer does not settle the tax answer. Which year an item of gross income is taken into account turns on the taxpayer’s own method and the tests that come with it, set out in accrual accounting, so one engagement can land in a different period on the return than it does on the books.
Revenue Recognition and the Matching Principle
The two answer opposite halves of the same period question. Recognition fixes the period the revenue belongs to, and the matching principle fixes the period of the expense that produced it.
Common Questions
The standard sets out a five step model rather than five recognition criteria. The nearest thing to a five-part test is the contract test inside the first step. An entity accounts for a contract with a customer that is within the Topic’s scope only when all of these are met: the parties have approved the contract and are committed to perform, the entity can identify each party’s rights, it can identify the payment terms, the contract has commercial substance, and it is probable the entity will collect substantially all of the consideration it will be entitled to (FASB, Accounting Standards Update 2016-12, paragraph 606-10-25-1).
Topic 606 of the FASB Accounting Standards Codification. It reaches a contract only where the counterparty is a customer, a party that has contracted with the entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration (FASB, Accounting Standards Update 2014-09, paragraph 606-10-15-3). Lease contracts, insurance contracts, financial instruments, and guarantees other than product or service warranties sit under Topics of their own.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own unbilled work and revenue schedules through a trial task before anything client facing depends on it.
