Revenue is one of the most important key performance indicators (KPIs) used by investors when assessing a company’s performance and prospects.
Revenue recognition represents one of the highest risks on financial statements, and it is one of the leading causes of restatements. Every publicly traded company has to follow the
guidelines set by the Securities and Exchange Commission (SEC) to communicate their financials effectively to investors. Based on the operations in different countries, businesses sometimes need to comply with more than one set of standards.
Most of the companies located in North America or Europe comply with generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). Recently, the standards-setters developed new revenue-related standards (IFRS 15 and Accounting Standards Codification [ASC] 606), which ensure clarity and transparency in reporting revenue. These new guidelines require a substantial change in the way currently revenue is being reported compared to the new revenue recognition standards.
The underlying principle of the new standard is that an entity will recognize revenue to depict the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services.
The standard consists of a five-step approach as follows:
Fig : 5 steps Framework
Lets take a quick look on Step 1:
1.IDENTIFY THE CONTRACT WITH A CUSTOMER
ASC 606 dictates that a business can account for a contract when all these criteria are met.
- Both parties should approve the contract (in writing, orally, or via some other agreed-upon practice)
- Both parties can identify what goods or services are to be transferred to the customer
- Accounting for the contract will need to be applied when all of the following occur:
- The parties have approved the contract and intend to perform their respective obligations.
- Each party's rights regarding the goods or services to be transferred can be identified.
- The payment terms can be identified.
- The risk, timing, or amount of the entity's future cash flows are expected to change (contract has commercial substance).
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services transferred
Regarding the collectability criteria, the entity will assess at the inception of the contract whether it is probable it will collect the transaction price.
Credit losses arising from a contract that was probable of collection at inception will be recognized as an expense in the income statement.
For Contract Modifications - Accounted for as a separate contract if the modification adds one or more distinct performance obligations and the price increases accordingly. Otherwise, a modification is accounted for as an adjustment to the original contract, either prospectively or through a cumulative catch-up adjustment depending on whether the remaining goods or services in the contract are distinct
to be continued :