A Guide to Revenue Recognition in 2 Simple Steps

In 2007 revenue recognition became a focus of mine when I started working at a software development firm that was publicly traded. Initially I was assigned with improving part of the revenue recognition processes and the accounting systems supporting it. From 2007 through 2018 I eventually worked on all the revenue recognition accounting processes and systems as a project manager as well as an accounting line manager responsible for helping create the income statement each quarter.

Here is a simple two-step guide that I think will prove extremely useful in managing work efforts, work teams, colleagues and auditors regarding revenue recognition.  It will guide you to quickly set accounting policy, implement the policy in a process and automate what you can of the process.  It will keep you from getting lost in the 700-page ASC 606 update or any large corporate contracts. This article is intended for Chief Financial Officers, Controllers and Revenue Accountants as well as the Information Technology team members who support them.  I found this structure always quickly guided me through important and complex work where revenue and earnings were on the line.

Below is the very simple two-step process.

Revenue Recognition fundamentally has two steps in my opinion. The first is to have a clear contract for the sale of goods or services and the second step is the delivery or performance of the goods or services. We will start with the contract and its three essential elements in a specified order. I managed contract operations and billing in addition to revenue recognition. It was in managing the billing that the three essential elements of a clear contract became evident to me. 

A Clear Sales Contract With 3 Elements in Order

All of us who are experienced large corporate financial managers are familiar with the lengthy and detailed contracts that contain obscure legal language. Attorneys have their many reasons for the paragraphs or structures of the modern corporate contract to protect the corporation from lawsuits and any potential regulatory problems or penalties. All this legal protection wording can be separated from the essential contract that is the economic transaction taking place. When I read an existing contract I spend the time to separate what is the essential economic transaction wording from the legal protections wording. If you are drafting the contract you can use the three-point check list to make sure nothing of the essential economic transaction is missing or unclear. If you are reading a contract that is already signed you can read it looking to see if it is clear on the three essential elements. The short version of a clear sales contract is Product, Price and Payment. The longer version is below.

Step 1– Clear Sales Contract 1. Products and Services: Your first element of the first step in rev rec (a clear sales contract) is to determine what product or service you are dealing with. I use the word “determine” because we need this foundation of knowing exactly the products and services we are going to recognize revenue for. If we just identify the product, we can have some ambiguity around what product or service we are recognizing revenue for. Once we determine exactly the products and or services we are dealing with we can quickly and easily move onto the price and payment terms. If we are unclear in our determination of the products or services, we will most likely have difficulty determining the price or payment terms. 

If you are doing the accounting for a contract with a customer but you were not involved in the drafting of the contract you can often find contracts confusing. I always found understanding what products and services are being sold an important and frequent problem. Once I develop a good understanding of the product or service being sold by the company it is easier to determine if there is some flaw in the contract around the products or services that affects rev rec. In my work I have frequently developed a products and services model to be able to handle all the different situations that I would encounter. Modeling products and services in a large corporation is its own topic for another article. For this general rev rec guide just be aware that if you are fuzzy on the products or services it can easily trip you up later when try to pull together price, payment and delivery for revenue recognition purposes.

We have three basic work efforts to use this guide on and they are 1) Setting Accounting Policy, 2) Implementing Accounting Policy in a Process and 3) Automating the Accounting Process. When we do accounting work, we often review things and jump around between the three work efforts of Policy, Implementation and Automation. I always found going back to this simple revenue recognition guide to be the quickest way to jump around gathering information but never get lost in the details.  The two-step process is too simple to forget once it is printed out and put in front of you as you work. I also found the three essential elements of a contract are again too simple to forget.

The ASC 606 guidance uses the term performance obligation to describe either a product or a service. In this guide I use the terms of either product or service to be clear. For business people who are not accounting professionals the use of “product” or “service” is very clear. The word “performance” in laymen’s terms is only related to services and I therefore use “product or service” where “performance obligation” is used to help make clear what we are doing and why.

Step 1– Clear Sales Contract 2. Price of the Products and Services: The price of the product is also fundamental in revenue recognition. If the price is not clearly defined or there is not a clear pricing mechanism, like how much usage of a product or service occurs in a given time period then we cannot recognize revenue easily. Since our first step was to determine our products and services we can easily think about the price and any complexity around the pricing of the product or service. In the ASC 606 guidance they have two distinct process steps of determining a price and then allocating the price.  Under this simpler model determining the price and any allocation that might be required is all covered under determining the price of the product or service. We already determined exactly the product or service we are evaluating in our first element of a clear sales contract and therefore allocating price is easier. Variable consideration and discounting both fall under this second element of determining the price of what was being sold in the contract.

Step 1– Clear Sales Contract 3. When to Pay for the Products and Services: Now that we have a product and service listing and a price for each product and service looking for the payment terms is already half done. If we are unclear on the product or service or the price then determining when the money is due is difficult to think through. Payment terms follow the price that is to be paid and the price follows the exact product sold.

If you agree to sell something and have a clear price but then allow the buyer to pay you twenty years from now, we all know revenue recognition is extremely doubtful until that payment is received.  Anyone who is not an accountant knows to get your money in some reasonable time frame and or being assured of getting it in a longer time frame are essential to any sort of trade or transaction. Thinking in these basic terms of getting your money in a reasonable time frame or being assured you will get it has helped me sort through many forms of contracts and payments across multiple industries. 

This is one area where the accounting guidance changed when ASC606 was put in place. The new standard recognizes that payments greater than one year into the future are a form of financing the purchase. In this simple model of three essential elements of a contract we find financing in the payment element of the contract. If there is a significant financing element the guidance tells us we need to establish what amount of the price is the loan and what is the interest to be earned.

This financing element is the only concept where we need to back track in a three-step process of determining Product, Price and Payment.  It is only in examining the payment terms where we determine that a loan is taking place in the contract. Other than financing the purchase all other contracts can be examined in just three simple steps of Product, Price and Payment.

Step 2- Performance or Delivery Occurs

If we have already completed step one with its three clear sales contract elements then determining if a product is delivered or not is a relatively simple process. We may have to hunt for information regarding evidence of delivery but at least we are clear on the product. Looking to see if an auto part or toaster has been shipped is straight forward for the most part. The same is true for services that we have clearly determined as being sold in the contract. If it is a service of a doctor’s consultation or a service of providing telephone support for a software product, we know exactly what we are looking.

That completes the detailed description of the revenue recognition guide. We have walked through the two major steps and the three essential elements of a clear sales contract. The three essential elements are best addressed in order of Product, Price and Payment.

My work in the software and services industry among others has a lot of complexity around revenue recognition and I do not pretend that this structure addresses them all. However, I have found this structure always oriented me quickly and helped me confidently solve problems. The concept of the right to cancel a contract or the need for a customer to “accept” the software and its functioning are two examples of such complexities. The right to cancel can be examined in the light of the three-point check list on the clarity of the customer contract. If the customer has the right to cancel and return the product then we have to assess the probability of cancellation or put a time frame around when the cancellation right ends. The idea of a right to cancel then voids whether there is a contract for the sale of the product in the first place. There are many more potentially complex issues like cancellations but for all that I have come across in software and services and other industries in the last 12 years this simple two step process and the clear sales contract check list of three elements has always helped me get revenue recognition work done quickly. I hope you find this a useful addition to your tool box.