revenue recognition assignment

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Revenue Recognition: What It Means in Accounting and the 5 Steps

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

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What Is Revenue Recognition?

Revenue recognition is a generally accepted accounting principle (GAAP) that identifies the specific conditions in which revenue is recognized and determines how to account for it. Revenue is typically recognized when a critical event has occurred, when a product or service has been delivered to a customer, and the dollar amount is easily measurable to the company.

Key Takeaways

• Revenue recognition is a generally accepted accounting principle (GAAP) that stipulates how and when revenue is to be recognized.
• The revenue recognition principle using accrual accounting requires that revenues are recognized when realized and earned–not when cash is received.
• The revenue recognition standard, ASC 606, provides a uniform framework for recognizing revenue from contracts with customers.

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Understanding Revenue Recognition

Revenue is at the heart of all business performance. Regulators know how tempting it is for companies to push the limits on what qualifies as revenue , especially when not all revenue is collected when the work is complete. For example, attorneys charge their clients in billable hours and present the invoice after work is completed. Construction managers often bill clients on a percentage-of-completion method.

The revenue recognition principle, a feature of accrual accounting , requires that revenues are recognized on the income statement in the period when realized and earned—not necessarily when cash is received. 

• Realized revenue means that goods or services have been received by the customer, but payment for the good or service is expected later.
• Earned revenue accounts for goods or services that have been provided or performed, respectively.

The revenue-generating activity must be fully or essentially complete for it to be included in revenue during the respective accounting period. Also, there must be a reasonable level of certainty that earned revenue payment will be received. Lastly, according to the matching principle, the revenue and its associated costs must be reported in the same accounting period.

The revenue recognition principle of ASC 606 requires that revenue is recognized when the delivery of promised goods or services matches the amount expected by the company in exchange for the goods or services.

Revenue accounting is fairly straightforward when a product is sold and the revenue is recognized when the customer pays for the product. However, accounting for revenue can get complicated when a company takes a long time to produce a product. As a result, there are several situations in which there can be exceptions to the revenue recognition principle.

Analysts, therefore, prefer that the revenue recognition policies for one company are also standard for the entire industry . Having a standard revenue recognition guideline helps to ensure that an apples-to-apples comparison can be made between companies when reviewing line items on the income statement . Revenue recognition principles within a company should remain constant over time as well, so historical financials can be analyzed and reviewed for seasonal trends or inconsistencies.

Accounting Standards Codification (ASC) 606

On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606. This highlights how revenue from contracts with customers is treated, providing a uniform framework for recognizing revenue from this source.

The old guidance was industry-specific, which created a system of fragmented policies. The updated revenue recognition standard is industry-neutral and, therefore, more transparent . It allows for improved comparability of financial statements with standardized revenue recognition practices across multiple industries.

There are five steps needed to satisfy the updated revenue recognition principle:

• Identify the contract with the customer. This involves agreeing on the terms of the contract, including payment, the delivery of goods and services, and consequences if any obligations aren't met. Contracts may come in written form or may begin as verbal agreements.
• Identify contractual performance obligations. In this case, it's important to outline the specific goods or services behind the agreement.
• Determine the amount of consideration/price for the transaction. This isn't just about the price of goods and services but also includes other factors, such as discounts, return policies, and additional fees.
• Allocate the determined amount of consideration/price to the contractual obligations. This step involves any specific selling price to every single obligation.
• Recognize revenue when the performing party satisfies the performance obligation. This should only be done once the transaction is complete and your obligation is fulfilled. Revenue can only be recognized once this is done.

There are certain conditions that businesses must meet as per IFRS requirements. According to the IFRS, these requirements fall into three different categories that are needed for contracts to exist. The table below highlights each one:

Performance indicates the seller has fulfilled a majority of their expectations in order to get payment. Collectability refers to the seller's expectation to be paid. Measurability, on the other hand, relates to the matching principle wherein the seller can match the expenses with the money earned from the transaction.

GAAP Revenue Recognition Principles

Generally accepted accounting principles require that revenues are recognized according to the revenue recognition principle, which is a feature of accrual accounting. This means that revenue is recognized on the income statement in the period when realized and earned—not necessarily when cash is received.

The revenue-generating activity must be fully or essentially complete for it to be included in revenue during the respective accounting period. Also, there must be a reasonable level of certainty that earned revenue payment will be received. Lastly, according to the matching principle, the revenue and its associated costs must be reported in the same accounting period.

Do All Businesses Need to Follow Revenue Recognition Principles?

Revenue recognition is generally required of all public companies in the U.S. according to generally accepted accounting principles. The requirements for tend to vary based on jurisdiction for other companies. In many cases, it is not necessary for small businesses as they are not bound by GAAP accounting unless they intend to go public.

Why Is Revenue Recognition Important?

Public companies are required to report their financial statements based on GAAP accounting. Revenue recognition is one of the principles associated with GAAP reporting. This principle means that revenue must be recognized at the moment it is earned. This is an important consideration for two reasons. Not only does it prevent companies from cooking their books but it also provides an accurate picture of the financial health of a corporation.

What Is Needed to Satisfy the Revenue Recognition Principle?

The five steps needed to satisfy the updated revenue recognition principle are: (1) identify the contract with the customer; (2) identify contractual performance obligations; (3) determine the amount of consideration/price for the transaction; (4) allocate the determined amount of consideration/price to the contractual obligations; and (5) recognize revenue when the performing party satisfies the performance obligation.

Revenue is a key metric for any business. Certain businesses must abide by regulations when it comes to the way they account for and report their revenue streams. Public companies in the U.S. must abide by generally accepted accounting principles, which sets out principles for revenue recognition. This prevents anyone from falsifying records and paints a more accurate portrait of a company's financial situation.

Financial Accounting Standards Board. " Financial Accounting Series: Accounting Standards Update No. 2016-10, April 2016, Revenue from Contracts with Customers (Topic 606) ."

Financial Accounting Standards Board. " Revenue Recognition ."

Association of International Certified Professional Accountants. " Financial Reporting Brief: Roadmap to Understanding the New Revenue Recognition Standards ." Page 2.

IFRS. " IFRS 15 Revenue from Contracts with Customers ."

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A guide to revenue recognition

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A guide to revenue recognition  assists middle-market companies in applying the revenue recognition model in Topic 606, “Revenue from Contracts with Customers,” of the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC). ASC 606 provides a robust framework for recognizing revenue, and upon its effective date, replaced almost all pre-existing revenue recognition guidance, including industry-specific guidance, in U.S. generally accepted accounting principles (legacy GAAP).

Our comprehensive guide includes in-depth discussion and numerous examples on:

• All the critical aspects of ASC 606, including its scope, five-step revenue recognition model, and presentation and disclosure requirements
• ASC Subtopic 340-40, “Other Assets and Deferred Costs – Contracts with Customers"
• ASC Subtopic 610-20, “Other Income – Gains and Losses from the Derecognition of Nonfinancial Assets”
• Commonly asked questions that arise in practice
• Significant differences between the new guidance and legacy GAAP

For a condensed discussion of the important concepts in ASC 606, refer to the executive summary in Chapter 1 of  the guide . The May 2024 edition of the guide has been updated to address various issues encountered in practice. A summary of the significant changes made in the May 2024 edition can be found in Appendix F of the  guide .

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9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions

You own a small clothing store and offer your customers cash, credit card, or in-house credit payment options. Many of your customers choose to pay with a credit card or charge the purchase to their in-house credit accounts. This means that your store is owed money in the future from either the customer or the credit card company, depending on payment method. Regardless of credit payment method, your company must decide when to recognize revenue. Do you recognize revenue when the sale occurs or when cash payment is received? When do you recognize the expenses associated with the sale? How are these transactions recognized?

Accounting Principles and Assumptions Regulating Revenue Recognition

The main revenue recognition objective is to recognize revenue after the company’s performance obligation. This performance obligation is the performance of services or the delivery of goods being carried out in return for an amount of consideration (often cash) the company expects to receive from the customer. To know exactly when and how much revenue to recognize, companies follow FASB’s five-step revenue recognition process in which revenue is recognized at the fifth step. This may not necessarily be when cash is collected, as will be illustrated in a later example. Revenue can be recognized when all of the following criteria have been met:

• Identify the contract with the customers.
• Identify the separate performance obligations in the contract.
• Determine the transaction price.
• Allocate the transaction price to the separate performance obligations.
• Recognize revenue when each performance obligation is satisfied.

While a detailed look at each of these five requirements is too involved for an introductory course, we can use a simple example to show the five steps. First, it is important to remember that the accrual accounting method aligns with this principle, and it records transactions related to revenue earnings as the performance obligations are met, not when cash is collected. For example, a landscaping company signs a $600 contract with a customer (step 1) to provide landscaping services for the next six months (step 2) for a total fee of $600 (step 3). Assume the landscaping workload is distributed evenly throughout the six months. The customer sets up an in-house credit line with the company, to be paid in full at the end of the six months. The landscaping company records revenue earnings each month (step 4) as they fulfill their performance obligation, which is providing the landscape service as agreed to with the customer. The landscaping company will record one month of revenue ($100) each month as it meets its contractual requirement, or in other words, fulfills its performance obligation, even though the customer has not yet paid cash for the service (step 5).

Let’s say that the landscaping company also sells gardening equipment. It sells a $200 package of gardening equipment to a customer who pays on credit. While this “contract” is not in writing, the company has an unwritten contract to transfer new, unbroken equipment to the customer for the agreed upon price—even if the company is getting the cash in the future. The landscaping company will recognize revenue $200 immediately, given that they provided the customer with the gardening equipment (product) and thus have completed their performance obligation, even though the customer has not yet paid cash for the product. All five steps essentially occurred simultaneously in this example, as would be true with many retail transactions.

Accrual accounting also incorporates the matching principle (otherwise known as the expense recognition principle ), which instructs companies to record expenses related to revenue generation in the period in which they are incurred. The principle also requires that any expense not directly related to revenues be reported in an appropriate manner. For example, assume that a company paid $6,000 in annual real estate taxes. The principle has determined that costs cannot effectively be allocated based on an individual month’s sales; instead, it treats the expense as a period cost. In this case, it is going to record 1/12 of the annual expense as a monthly period cost. Overall, the “matching” of expenses to revenues projects a more accurate representation of company financials. When this matching is not possible, then the expenses will be treated as period costs.

For example, when the landscaping company sells the gardening equipment, there are costs associated with that sale, such as the costs of materials purchased or shipping charges. The cost is reported in the same period as revenue associated with the sale. There cannot be a mismatch in reporting expenses and revenues; otherwise, financial statements are presented unfairly to stakeholders. Misreporting has a significant impact on company stakeholders. If the company delayed reporting revenues until a future period, net income would be understated in the current period. If expenses were delayed until a future period, net income would be overstated.

Let’s turn to the basic elements of accounts receivable, as well as the corresponding transaction journal entries.

Ethical Considerations

Ethics in revenue recognition.

Because each industry typically has a different method for recognizing income, revenue recognition is one of the most difficult tasks for accountants, as it involves a number of ethical dilemmas related to income reporting. To provide an industry-wide approach, Accounting Standards Update No. 2014-09 and other related updates were implemented to clarify revenue recognition rules. The American Institute of Certified Public Accountants (AICPA) announced that these updates would replace U.S. GAAP’s current industry-specific revenue recognition practices with a principle-based approach, potentially affecting both day-to-day business accounting and the execution of business contracts with customers. 1 The AICPA and the International Federation of Accountants (IFAC) require professional accountants to act with due care and to remain abreast of new accounting rules and methods of accounting for different transactions, including revenue recognition.

The IFAC emphasizes the role of professional accountants working within a business in ensuring the quality of financial reporting: “Management is responsible for the financial information produced by the company. As such, professional accountants in businesses therefore have the task of defending the quality of financial reporting right at the source where the numbers and figures are produced!” 2 In accordance with proper revenue recognition, accountants do not recognize revenue before it is earned.

Concepts In Practice

Gift card revenue recognition.

Gift cards have become an essential part of revenue generation and growth for many businesses. Although they are practical for consumers and low cost to businesses, navigating revenue recognition guidelines can be difficult. Gift cards with expiration dates require that revenue recognition be delayed until customer use or expiration. However, most gift cards now have no expiration date. So, when do you recognize revenue?

Companies may need to provide an estimation of projected gift card revenue and usage during a period based on past experience or industry standards. There are a few rules governing reporting. If the company determines that a portion of all of the issued gift cards will never be used, they may write this off to income. In some states, if a gift card remains unused, in part or in full, the unused portion of the card is transferred to the state government. It is considered unclaimed property for the customer, meaning that the company cannot keep these funds as revenue because, in this case, they have reverted to the state government.

Short-Term Revenue Recognition Examples

As mentioned, the revenue recognition principle requires that, in some instances, revenue is recognized before receiving a cash payment. In these situations, the customer still owes the company money. This money owed to the company is a type of receivable for the company and a payable for the company’s customer.

A receivable is an outstanding amount owed from a customer. One specific receivable type is called accounts receivable. Accounts receivable is an outstanding customer debt on a credit sale. The company expects to receive payment on accounts receivable within the company’s operating period (less than a year). Accounts receivable is considered an asset, and it typically does not include an interest payment from the customer. Some view this account as extending a line of credit to a customer. The customer would then be sent an invoice with credit payment terms. If the company has provided the product or service at the time of credit extension, revenue would also be recognized.

For example, Billie’s Watercraft Warehouse (BWW) sells various watercraft vehicles. They extend a credit line to customers purchasing vehicles in bulk. A customer bought 10 Jet Skis on credit at a sales price of $100,000. The cost of the sale to BWW is $70,000. The following journal entries occur.

Accounts Receivable increases (debit) and Sales Revenue increases (credit) for $100,000. Accounts Receivable recognizes the amount owed from the customer, but not yet paid. Revenue recognition occurs because BWW provided the Jet Skis and completed the earnings process. Cost of Goods Sold increases (debit) and Merchandise Inventory decreases (credit) for $70,000, the expense associated with the sale. By recording both a sale and its related cost entry, the matching principle requirement is met.

When the customer pays the amount owed, the following journal entry occurs.

Cash increases (debit) and Accounts Receivable decreases (credit) for the full amount owed. If the customer made only a partial payment, the entry would reflect the amount of the payment. For example, if the customer paid only $75,000 of the $100,000 owed, the following entry would occur. The remaining $25,000 owed would remain outstanding, reflected in Accounts Receivable.

Another credit transaction that requires recognition is when a customer pays with a credit card ( Visa and MasterCard , for example). This is different from credit extended directly to the customer from the company. In this case, the third-party credit card company accepts the payment responsibility. This reduces the risk of nonpayment, increases opportunities for sales, and expedites payment on accounts receivable. The tradeoff for the company receiving these benefits from the credit card company is that a fee is charged to use this service. The fee can be a flat figure per transaction, or it can be a percentage of the sales price. Using BWW as the example, let’s say one of its customers purchased a canoe for $300, using his or her Visa credit card. The cost to BWW for the canoe is $150. Visa charges BWW a service fee equal to 5% of the sales price. At the time of sale, the following journal entries are recorded.

Accounts Receivable: Visa increases (debit) for the sale amount ($300) less the credit card fee ($15), for a $285 Accounts Receivable balance due from Visa . BWW’s Credit Card Expense increases (debit) for the amount of the credit card fee ($15; 300 × 5%), and Sales Revenue increases (credit) for the original sales amount ($300). BWW recognizes revenue as earned for this transaction because it provided the canoe and completed the earnings process. Cost of Goods Sold increases (debit) and Merchandise Inventory decreases (credit) for $150, the expense associated with the sale. As with the previous example, by recording both a sale and cost entry, the matching principle requirement is met. When Visa pays the amount owed to BWW, the following entry occurs in BWW’s records.

Cash increases (debit) and Accounts Receivable: Visa decreases (credit) for the full amount owed, less the credit card fee. Once BWW receives the cash payment from Visa , it may use those funds in other business activities.

An alternative to the journal entries shown is that the credit card company, in this case Visa , gives the merchant immediate credit in its cash account for the $285 due the merchant, without creating an account receivable. If that policy were in effect for this transaction, the following single journal entry would replace the prior two journal entry transactions. In the immediate cash payment method, an account receivable would not need to be recorded and then collected. The separate journal entry—to record the costs of goods sold and to reduce the canoe inventory that reflects the $150 cost of the sale—would still be the same.

Here’s a final credit transaction to consider. A company allows a sales discount on a purchase if a customer charges a purchase but makes the payment within a stated period of time, such as 10 or 15 days from the point of sale. In such a situation, a customer would see credit terms in the following form: 2/10, n/30. This particular example shows that a customer who pays his or her account within 10 days will receive a 2% discount. Otherwise, the customer will have 30 days from the date of the purchase to pay in full, but will not receive a discount. Both sales discounts and purchase discounts were addressed in detail in Merchandising Transactions .

Maine Lobster Market

Maine Lobster Market (MLM) provides fresh seafood products to customers. It allows customers to pay with cash, an in-house credit account, or a credit card. The credit card company charges Maine Lobster Market a 4% fee, based on credit sales using its card. From the following transactions, prepare journal entries for Maine Lobster Market.

Jamal’s Music Supply

Jamal’s Music Supply allows customers to pay with cash or a credit card. The credit card company charges Jamal’s Music Supply a 3% fee, based on credit sales using its card. From the following transactions, prepare journal entries for Jamal’s Music Supply.

• 1 American Institute of Certified Public Accountants (AICPA). “Revenue from Contracts with Customers.” Revenue Recognition . n.d. https://www.aicpa.org/interestareas/frc/accountingfinancialreporting/revenuerecognition.html
• 2 International Federation of Accountants (IFAC). “Roles and Importance of Professional Accountants in Business.” n.d. https://www.ifac.org/news-events/2013-10/roles-and-importance-professional-accountants-business

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What is Revenue Recognition?

Conditions for revenue recognition, revenue recognition from contracts, steps in revenue recognition from contracts, gaap revenue recognition principles, additional resources, revenue recognition.

An accounting principle that outlines the specific conditions in which revenue is recognized

Revenue recognition is an accounting principle that outlines the specific conditions under which revenue is recognized. In theory, there is a wide range of potential points at which revenue can be recognized. This guide addresses recognition principles for both IFRS and U.S. GAAP.

According to the IFRS criteria, for revenue to be recognized, the following conditions must be satisfied:

• Risks and rewards of ownership have been transferred from the seller to the buyer.
• The seller loses control over the goods sold.
• The collection of payment from goods or services is reasonably assured.
• The amount of revenue can be reasonably measured.
• Costs of revenue can be reasonably measured.

Conditions (1) and (2) are referred to as Performance . Regarding performance, it occurs when the seller has done what is to be expected to be entitled to payment.

Condition (3) is referred to as Collectability . The seller must have a reasonable expectation that he or she will be paid for the performance.

Conditions (4) and (5) are referred to as Measurability. Due to the accounting guideline of the matching principle, the seller must be able to match the revenues to the expenses. Hence, both revenues and expenses should be able to be reasonably measured.

IFRS 15 , revenue from contracts with customers, establishes the specific steps for revenue recognition. It is important to note that there are some exclusions from IFRS 15 such as:

• Lease contracts (IAS 17)
• Insurance contracts (IFRS 4)
• Financial instruments (IFRS 9)

The five steps for revenue recognition in contracts are as follows:

1. Identifying the Contract

All conditions must be satisfied for a contract to form:

• Both parties must have approved the contract (whether it be written, verbal, or implied).
• The point of transfer of goods and services can be identified.
• Payment terms are identified.
• The contract has commercial substance.
• Collection of payment is probable.

2. Identifying the Performance Obligations

Some contracts may involve more than one performance obligation. For example, the sale of a car with a complementary driving lesson would be considered as two performance obligations – the first being the car itself and the second being the driving lesson.

Performance obligations must be distinct from each other. The following conditions must be satisfied for a good or service to be distinct:

• The buyer (customer) can benefit from the goods or services on its own.
• The good or service is separately identified in the contract.

3. Determining the Transaction Price

The transaction price is usually readily determined; most contracts involve a fixed amount. For example, a price of $20,000 for the sale of a car with a complementary driving lesson. The transaction price, in this case, would be $20,000.

4. Allocating the Transaction Price to Performance Obligations

The allocation of the transaction price to more than one performance obligation should be based on the standalone selling prices of the performance obligations.

For example, a contract involves the sale of a car with a complementary driving lesson. The total transaction price is $20,000. The standalone selling price of the car is $19,000 while the standalone selling price of the driving lesson is $1,000. The transaction price allocation would be as follows:

Note: The percentage of the total is simply the standalone price divided by the total standalone price. For example, the percentage of total for the car would be calculated as $19,000 / $20,000 = 95%.

5. Recognizing Revenue in Accordance with Performance

Recall the conditions for revenue recognition. Conditions (1) and (2) state that revenue would be recognized when the seller has done what is expected to be entitled to payment. Therefore, revenue is recognized as either:

• At a point in time; or

In the example above, the revenue associated with the car would be recognized at the point in time when the buyer takes possession of the car. On the other hand, the complementary driving lesson would be recognized when the service is provided.

The revenue recognition journal entries for the two performance obligations (car and driving lesson) would be as follows:

For the sale of the car and complimentary driving lesson:

Note: Revenue is recognized for the sale of the car ($18,050) but not for the complementary driving lesson because it has not yet been provided.

When the complementary driving lesson has been provided:

Note: Revenue is deferred until the driving lesson has been provided.

The Financial Accounting Standards Board (FASB) which sets the standards for U.S. GAAP has the following 5 principles for recognizing revenue:

• Identify the customer contract
• Identify the obligations in the customer contract
• Determine the transaction price
• Allocate the transaction price according to the performance obligations in the contract
• Recognize revenue when the performance obligations are met

Learn more about the principles on FASB’s website .

Thank you for reading CFI’s guide to Revenue Recognition. To keep advancing your career, the additional CFI resources below will be useful:

• Special Revenue Fund
• Three Statement Model
• Projecting Balance Sheet Line Items
• Contribution Analysis
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Revenue recognition: A Q&A guide for software and SaaS entities

Although today’s revenue recognition guidance applies the same accounting model across all industries, there are a number of unique considerations when accounting for software and software-as-a-service (SaaS) arrangements. As you delve into these arrangements, we've developed a series of Q&As to help you navigate common issues that arise. From determining contract term and assessing whether a software license is distinct to accounting for variable fees in a SaaS arrangement and much more, we hope to demystify the accounting and reporting implications.

Following are the eight issue areas addressed in the Q&A guide for software and SaaS entities:

Identifying the contract

Identifying the performance obligations

Determining the transaction price

Allocating transaction price

• Recognizing revenue

Contract modifications

Principal versus agent considerations

Costs to obtain a contract

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Revenue Recognition

Quick links.

• Brief: Revenue Recognition Primer for Audit Committees

Learning and Implementation Plan

• Revenue Recognition CPE and Learning Resources
• Revenue Recognition News

The Financial Accounting Standards Board’s (FASB) accounting standard on revenue recognition, FASB ASU No. 2014-09 , eliminates the transaction- and industry-specific guidance under current U.S. GAAP and replaces it with a principles-based approach. The guidance is already in effect for public companies (including certain NFPs and EBPs). With the issuance of FASB ASU No. 2020-05: Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842): Effective Dates for Certain Entities, other entities that have not yet issued financial statements or made financial statements available for issuance as of June 3, 2020 may elect to defer the effective date to be 2020 for annual reporting periods and in 2021 for interim periods. Those entities may also elect to follow the original effective date of annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019. The resources below can help your firm and clients be ready.

Audit and Accounting Guide

The AICPA Revenue Recognition Audit and Accounting Guide includes general accounting and auditing information to consider when implementing the new revenue recognition standard, as well as industry-specific considerations.

Use this roadmap to ensure your company understands the changes to GAAP, determine how you will adopt the new guidance, find resources to train staff and educate users about the changes they can expect in your company’s financial statements.

Understanding Tax Implications

The new standard will impact the financial reporting of almost every company. But what tax consequences could also result? Financial Reporting Brief:  Tax Effects of ASU 2014-09   examines this question.

Additional Free Resources for Clients

Your clients may be interested in this roadmap to understanding the new revenue recognition standards and this document designed to assist audit committees in ensuring organizations are prepared to adopt the standard.

The Financial Accounting Standards Board (FASB) has launched a new webpage,  Implementing New Standards , that addresses why and when the FASB positions organizations for a successful and smooth transition to new financial accounting and reporting standards. You may also be interested in checking out the FASB’s Revenue Recognition Implementation Q&A . It incorporates previously issued FASB staff and Transition Resource Group (TRG) memos and other educational materials into a user-friendly format.

PCPS Revenue Recognition Toolkit

This toolkit breaks down the new revenue recognition standard and provides firms with insights into how the standard will affect their engagements. Additional resources are coming soon. This toolkit is available to PCPS members .

Resources for auditors

Webcast—ASC 606: What Auditors Need to Know  (CPE credits: 2) This webcast will walk you through the five steps to recognizing revenue under ASC 606 and how you can improve your audit quality by avoiding four common missteps.

Documentation example Use this example of documentation for contracts to help you meet the documentation requirements of AU-C 230. It captures key terms and details from a contract with a customer.

Internal inspection aid If you review audit work, this resource will help guide you identify non-compliance with AU-C 540 during your firm’s internal inspection. This auditing estimates aid will also guide reviewers on ASC 606 considerations.

Practice aid: Considering management’s estimates within ASC 606 This practice aid walks you through the five steps to FASB’s Topic ASC 606, including associated potential risks of material misstatement, processes where the client should have established controls and examples of audit procedures to address risks.

From the Journal of Accountancy: Challenges to consider in auditing revenue recognition Learn more about the five steps to FASB’s Topic ASC 606 as well as common missteps to be aware of as you audit your clients.

Staff training presentation  This PowerPoint presentation (with speaker notes) is designed to support firms as they train audit personnel on how to audit clients with revenue subject to ASC 606.

Resources for auditors to stay independent

As your audit clients look to you for guidance in implementing this new standard, it's critical to keep independence considerations in mind. Here are a few resources to look to for maintaining your independence.

CPEA Report: Helping Attest Clients Implement the New Revenue Standard: Complying with the Independence Rules  (Open to non-CPEA members) This special report from the Center for Plain English Accounting (CPEA) will help in understanding independence boundaries when helping clients with the revenue recognition standard.

From the Journal of Accountancy: How auditors can stay independent while advising on revenue recognition With the revenue recognition standard in full effect, it may be an instinct to help clients who still feel left behind. The extent of that assistance could impair the firm's independence. Check out some best practices here to avoid crossing the lines of independence.

Journal of Accountancy quiz: Auditor independence and FASB’s revenue recognition standard How much guidance on the new revenue recognition standard can you offer your clients without compromising your audit independence? Take this quiz to find out how well you know the independence requirements relative to attest clients.

Ethically Speaking Podcast Give your eyes a break from reading and listen to these podcast episodes in the Ethically Speaking series to learn about what your firm can do to maintain independence while still being a valuable resource for your clients in the revenue recognition implementation process.

• Ep 9: Independence considerations when implementing FASB ASC 606
• Ep. 10: 606 SOS -- What happens if...

Other Resources

Webcasts and CPE courses available or coming soon.

Opportunities with CPE:

Revenue Recognition: Mastering the New FASB Requirements

• Online self-study course

Interpreting the New Revenue Recognition Standard: What All CPAs Need to Know

Archived webcasts (free, no CPE available):

• Understanding the New Revenue Recognition Standard
• FASB ASC 606 – Revenue Recognition: Asset Management Entities
• FASB ASC 606 – Revenue Recognition: Software Entities
• FASB ASC 606 – Revenue Recognition: Engineering and Construction Entities
• FASB ASC 606 – Revenue Recognition: Telecommunications Entities

Subsequent ASUs and FASB Staff Papers

Subsequent to the release of ASU 2014-09,  Revenue from Contracts with Customers (Topic 606) , FASB issued the following related accounting standard updates and staff papers:

• Update 2015-14 -  Deferral of the Effective Date
• Update 2016-08 -  Principal versus Agent Considerations (Reporting Revenue Gross versus Net)
• Update 2016-10 –  Identifying Performance Obligations and Licensing
• Update 2016-11 –  Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting (SEC Update)
• Update 2016-12 –  Narrow-Scope Improvements and Practical Expedients
• Update 2016-20 -  Technical Corrections and Improvements to Topic 606 ,  Revenue from Contracts with Customers
• Update 2017-13— Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842): Amendments to SEC Paragraphs Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments (SEC Update)
• Update 2017-14— Income Statement—Reporting Comprehensive Income (Topic 220), Revenue Recognition (Topic 605), and Revenue from Contracts with Customers (Topic 606): Amendments to SEC Paragraphs Pursuant to Staff Accounting Bulletin No.116 and SEC Release No. 33-10403 (SEC Update)
• Update 2018-18— Collaborative Arrangements (Topic 808): Clarifying the Interaction between Topic 808 and Topic 606
• Update 2019-08— Compensation—Stock Compensation (Topic 718) and Revenue from Contracts with Customers (Topic 606): Codification Improvements—Share-Based Consideration Payable to a Custom er
• Update 2020-05— Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842): Effective Dates for Certain Entities

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Accounting Documents Library

Revenue recognition policy.

Guide to understanding and writing the revenue recognition policy

Navigating the intricacies of revenue recognition can be a formidable task, whether you're an accounting student just starting out, a small business owner keen to ensure financial transparency, or a professional in need of a refresher. This detailed instructional guide is designed to demystify the process of crafting an effective revenue recognition policy, an essential aspect of financial accounting that lays the groundwork for your company's financial integrity.

The importance of revenue recognition policy

Revenue recognition is not just another box to tick on an accounting checklist. It is the bedrock upon which a company's financial health is measured. A well-crafted policy ensures that revenue is reported accurately and consistently across all sectors, instilling trust in investors and stakeholders, and maintaining compliance with accounting standards such as GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards). But beyond compliance, a clear revenue recognition policy can be a guiding document, informing strategic business decisions and serving as a tool for accountability and transparency.

Understanding revenue recognition

Before we begin drafting a policy, it's vital to grasp what revenue recognition truly entails. Revenue recognition refers to the incorporation of a company's sales earnings into its financial statements. It is crucial for businesses to have a detailed policy in place to outline when and how to recognize revenue in accordance with the principles that govern financial accounting.

What are the 5 criteria for revenue recognition?

There are five foundational criteria that must be met for revenue to be recognized. Firstly, it's essential to identify the customer and link revenue to the satisfaction of specific performance obligations. Secondly, pinpointing the transaction price – the expected amount from the exchange – is paramount. Thirdly, this transaction price needs to be allocated proportionally across the distinct performance obligations within a contract. Fourthly, revenue recognition should occur concurrently with, or as, an entity discharges a performance obligation by delivering the promised goods or services. Lastly, collectability is a key factor; revenue should only be recorded when it is probable that the entity will receive the consideration it is due for the provided goods or services. These criteria serve as the bedrock of trustworthy and consistent revenue accounting in an organization's financial narrative.

What are the 4 principles of revenue recognition?

Revenue recognition in the financial accounting realm is governed by four fundamental principles that ensure the accuracy and consistency of reported earnings. These principles are crucial for the preparation of reliable financial statements and adhere to the Generally Accepted Accounting Principles (GAAP).

• Identification is the inaugural step in revenue recognition, which involves confirming the occurrence of a transaction. This principle requires companies to verify that a contractual exchange, typically involving goods or services, has indeed transpired with a customer.
• Timing of revenue recognition is a critical aspect that dictates when the recognized revenue should be reflected in the accounts. It may correspond to a discrete event, such as a sale, or be distributed over time with ongoing service agreements.
• The Certainty principle pertains to the company's assurance regarding the receipt of revenue. It underscores the necessity for businesses to have a reasonable expectation that the recorded revenue will indeed be secured.
• Lastly, Collectability is essential to consider where revenue is acknowledged only if there is a high likelihood that payment will be collected. It requires an evaluation of the customer's creditworthiness and willingness to pay, ensuring that recognized revenues are not merely speculative.

Together, these four principles form the foundation of a robust revenue recognition framework, assuring stakeholders of the financial health and integrity of the reporting entity.

Key Components of a revenue recognition policy

Criteria for revenue recognition.

Revenue is recognized when it is realized or realizable and earned. This implies that the selling price can be collected, and the service is provided or goods are transferred, as specified by the contract terms. Defining the point at which this occurs is the foundation of your policy.

Timing and methods of recognition

This section details the specific time at which revenue should be recognized, either over time or at a specific point. It outlines the different methods you might use, such as when the risk and rewards of ownership have transferred or upon delivery.

Disclosure requirements

Financial statement users need to understand the extent of the company's activities that account for its revenue. This involves disclosing the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

Writing the revenue recognition policy

Crafting your company's revenue recognition policy is a step-by-step process. It demands precision and clarity to ensure that all stakeholders interpret the policy uniformly and can execute its principles consistently.

Step-by-step instructions

Identify revenue streams.

Segment your revenue into its various sources, whether that's product sales, services rendered, or contract milestones. Each stream may have distinct criteria for recognition.

Determine revenue recognition criteria

Take each revenue stream and apply the general criteria to the specific details of your business's transactions. Be granular — the devil is in the details when it comes to revenue recognition.

Document the policy clearly

Write with precision but maintain the document's accessibility. Clarity is essential, so use examples and plain language without sacrificing specificity.

Review and update regularly

Revenue recognition is not static. External factors may necessitate changes to your policy, and internal growth will constantly test its relevance. Regular reviews ensure your policy keeps pace with your business.

Tips for clarity and compliance

Plain language usage.

Avoid jargon where possible, and always explain any technical terms used. The goal is a document that any stakeholders with a basic financial understanding can follow.

Aligning with accounting standards

Your revenue recognition policy should be a harmonious entity with GAAP, IFRS, or other applicable accounting standards. It should serve as a translation of these standards into the specific context of your business.

A comprehensive and well-articulated revenue recognition policy is indispensable in the world of accounting and business. It is more than a compliance tool; it is a narrative of your company's financial operations. By following these clear instructions and pointers, you'll be on your way to forging a policy that not only meets the stipulations of accounting standards but also enhances your company's image and boosts stakeholder confidence.

Remember, your policy is a living document. It should evolve with your business's changes and challenges, all while maintaining its foundational voice. With diligence and a commitment to clarity, you'll craft a policy that stands as a testament to your business's commitment to financial wisdom and transparency.

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• Small Business
• The Top 10 Accounting Software for Small Businesses

A Small Business Guide to the Revenue Recognition Principle

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Our Small Business Expert

If your business uses accrual accounting, you should know and understand the revenue recognition principle, sometimes known as the revenue principle.

Why not take a few minutes and learn more about the revenue recognition principle and why it is important to your business.

Overview: What is the revenue recognition principle?

No matter what type of accounting your business is using, the revenue recognition principle remains the same.

The revenue recognition principle says that revenue should be recorded when it has been earned, not received. The revenue recognition concept is part of accrual accounting, meaning that when you create an invoice for your customer for goods or services, the amount of that invoice is recorded as revenue at that point, and not when the money is received from the customer.

This is one of the major differences between accrual basis accounting and cash basis accounting, since with cash accounting, revenue is recognized when payment is received, not when it’s earned.

Requirements for revenue recognition

The revenue recognition principle requires that you use double-entry accounting. Here are some additional guidelines that need to be followed in regards to the revenue recognition principle:

• An arrangement or agreement is in place between your business and your customer. What this means is that you have offered credit terms to your customer, and they have agreed to pay the invoice in the amount of time in order to fulfill those terms. For instance, you provide consulting services to Client A, with credit terms of Net 30. If Client A accepts those terms, they agree to pay your invoice within 30 days of the date of the invoice.
• The product or service that you are selling has been delivered or completed. This is one of the most important components of the revenue recognition principle, which is that revenue is recognized and recorded when services are rendered or the product delivered. In essence, this means that your portion of the agreement is complete.
• The cost has been determined. When you offer your services or sell products to clients, you must provide them with the cost of those services or products, with the cost finalized prior to recognizing the revenue.
• The amount billed is collectible. This is fairly straightforward and speaks to the importance of accurately vetting clients to determine their creditworthiness. Before you offer credit terms to clients, you should be reasonably sure that you can collect the balance due from them at a future date. This is not foolproof of course, because even properly vetted companies can pay their bills late at times, but this should be the exception, not the rule.
• If you have doubts about the collectability of an invoice, it should not be recognized as revenue. This is a tough one, since it’s unlikely that you will extend credit terms to a customer that you don’t think will be able to pay their bill. However, if this issue does arise, you should delay recognizing the revenue until the bill has been paid.
• If payment is received in advance of products or services, the revenue should be recognized only after services are rendered. For instance, if your business provides office cleaning services for $500 a month, and your customer pays you $1,500 for the next three months, the revenue would be recognized at $500 for the next three accounting cycles, rather than being recognized in total for the current accounting cycle.

What does the revenue recognition principle mean for businesses?

The revenue recognition principle enables your business to show profit and loss accurately, since you will be recording revenue when it is earned, not when it is received.

Using the revenue recognition principle also helps with financial projections; allowing your business to more accurately project future revenues. Recognizing revenue properly is also important for businesses that receive payment in advance of services, such as businesses that provide service contracts that require payment up front.

In order to recognize revenue properly, any business that receives payment upfront for services to be rendered must recognize that revenue only after the services have been performed. For instance, if you offer a yearly support contract to your customers for $12,000 annually, you would recognize revenue in the amount of $1,000 monthly for the next 12 months.

This is to record the initial customer deposit of $12,000.

This is to record the January payment since it has now been earned.

In Example 1, you would debit your cash account, since the money will be deposited. However, instead of applying it to an income account, you would place it in a Client Prepayment account, which will be gradually reduced until the complete $12,000 has been earned.

In Example 2, you would debit the Client Prepayment account, since you are reducing the balance by $1,000, while crediting your income account for the month of January, continuing to do a journal entry each month through the month of December in order to properly account for the earned revenue.

Example of the revenue recognition principle

Here are two simple revenue recognition examples:

• Your business provides tax services for a client. Once their tax return has been completed, you forward a copy of your invoice to your client, who has agreed to pay the bill within the next 30 days (net 30). You can recognize the revenue immediately, since the services have already been delivered.
• You provide monthly accounting services for your client. That client pays you in advance for the entire year, with payment received January 2 for the entire year. Remember, you can only recognize revenue as it’s earned, so while you can recognize earned revenue for January, you will have to wait until February in order to recognize February’s revenue, with revenue recognized each month through December, as services are rendered.

If you’re a sole proprietor operating on a cash basis, chances are that using the revenue recognition principle is not necessary. However, if your business operates on an accrual basis, and you wish to use accounting ratios such as the accounts receivable turnover ratio, it’s a good idea for you to understand and use the revenue recognition principle in order to ensure that your business is recording and reporting revenue properly.

It’s important that during the bookkeeping and accounting process, that you recognize revenue only after goods or services have been provided. As the examples above have shown, if your customer pays for an annual service contract, the revenue from that contract must be recognized as it’s earned, not when it’s received.

If you’re using accrual accounting for your business, it’s vital that you understand the revenue recognition principle properly. Using this principle will ensure that you are producing accurate financial statements in real time. Using this principle also helps you better account for revenue in the period that it’s earned, rather than the period in which it’s received.

Why understanding the revenue recognition principle is important

In order to produce accurate financial statements, it’s important to understand and properly use the revenue recognition principle. Using this principle allows you to record your revenue as it’s earned, thus providing a more accurate profit and loss statement, a must if you’re looking for investors or business financing.

If you’re currently in the market for small business accounting software that will help you better track revenue, be sure to check out The Ascent’s accounting reviews .

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• TAX ACCOUNTING

Revenue recognition: Time to implement the final regulations

• Tax Accounting

Editor: Greg A. Fairbanks, J.D., LL.M.

The quest to properly report revenue for federal income tax purposes continues as 2021 tax filings will provide yet another opportunity for taxpayers to assess and adjust their revenue recognition methods. In 2018, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115 - 97 , amended the Sec. 451 statutory provisions, which substantially modified long - standing revenue recognition rules. Further, late in 2020, the IRS released final revenue recognition regulations under Sec. 451 that provided much - needed clarity on how taxpayers should apply the new Sec. 451 provisions. Lastly, in 2021, Treasury and the IRS released Rev. Proc. 2021 - 34 , providing the required procedural guidance needed for taxpayers to comply with Sec. 451 and the final revenue recognition regulations issued thereunder.

Changes to revenue recognition

The new revenue recognition rules provided under the TCJA contained many significant changes for taxpayers. Among such changes are the following:

• Sec. 451(b) effectively modified the "all-events test" to require accrual-method taxpayers to recognize revenue at the earliest of when revenue is due, earned, received, or recognized in an applicable financial statement (later termed the AFS income-inclusion rule in the final regulations). This is significant, as the manner in which revenue is recognized for financial statement purposes was also modified under FASB Accounting Standards Codification Topic 606, Revenue From Contracts With Customers , and IFRS 15 (the new standards). These new financial statement rules often resulted in an acceleration of revenue, which, in turn, could result in an acceleration of taxable income. Lastly, it is important to note that Sec. 451(b) should not be construed as simple book/tax conformity because application of the provision is much more complicated than a conformity rule.
• Sec. 451(c) codified and modified the deferral method for advance payments permitted under Rev. Proc. 2004-34. It is important to note that the final regulations obsolete Rev. Proc. 2004-34 for tax years beginning on or after Jan. 1, 2021. As such, taxpayers need to assess the application of Sec. 451(c), and the regulations thereunder, to their particular facts and circumstances to determine their ability to defer revenue recognition relating to advance payments.

Final regulations

As one might expect, the new provisions provided under the TCJA left taxpayers with many questions relating to their proper application. In addition, taxpayers with newfound acceleration of taxable income under Sec. 451(b) were looking for some form of relief from the AFS income - inclusion rule. Treasury responded to taxpayers' concerns by issuing final regulations under Sec. 451 at the end of 2020. These regulations are generally required to be implemented by taxpayers no later than tax years beginni ng on or after Jan. 1, 2021.

Perhaps two of the most significant opportunities are contained in Regs. Sec. 1. 451 - 3 and relate to contractual enforceable right provisions and an optional cost - of - goods offset.

• Enforceable right: Under the enforceable-right rule, taxpayers may exclude from taxable income (and, accordingly, Sec. 451(b) recognition) amounts to which the taxpayer does not have an enforceable right to recover if the taxpayer's customer were to terminate the contract to which the income relates on the last day of the tax year. The determination of whether the taxpayer has an enforceable right is governed by the contract and applicable federal, state, or international law. As such, taxpayers need to possess a thorough understanding of the facts surrounding a transaction as well as how federal, state, or international law is applied to the contractual terms of that transaction. Accordingly, an analysis of enforceable-right provisions can prove burdensome and time-consuming for some taxpayers. Taxpayers that do not want to undertake the analysis each year may instead adopt the alternative method, which does not make the annual adjustments to AFS revenue for the enforceable-right rule.
• Cost offset: In the case of certain types of transactions involving the production of goods over a period of time, financial statement reporting may now recognize (accelerate) the income and the related production costs over time as the entity produces the goods, rather than recognizing both at the point in time that the goods are delivered to the customer. Pursuant to the AFS income-inclusion rule, tax recognition of this production income may be accelerated such that tax recognition will match the book timing for revenue recognition. However, the related cost of goods sold (COGS) may not be accelerated for tax purposes. As a result, there can be a mismatching of revenue and COGS for tax purposes. In response to taxpayer concerns over this potential mismatch, Treasury provided the cost-offset method in the final regulations. The method does not provide a COGS deduction when goods are produced over a period of time and an amount is accelerated into income under the AFS income-inclusion rule. Instead, the final regulations allow a taxpayer to reduce the amount of revenue it would otherwise be required to include under the AFS income-inclusion rule for the tax year by the cost of goods related to the item of inventory for the tax year.

Under both the AFS income - inclusion rule and the alternative method, Regs. Sec. 1. 451 - 3 requires three additional adjustments to AFS revenue for purposes of Sec. 451(b): increase revenue for any reductions taken into account in the financial statements for liabilities properly accounted for under Sec. 461 or as COGS (however, see the cost - offset method above); increase revenue for amounts that were anticipated to be in dispute or uncollectible; and decrease revenue for increases to the transaction price as a result of a significant financing component.

As indicated above, Sec. 451(c), as supported by the final regulations (Regs. Sec. 1. 451 - 8 ), codifies and modifies Rev. Proc. 2004 - 34 such that certain advance payments are eligible for the deferral method of accounting. To qualify as an advance payment, the payment must be eligible to be included in income in the year of receipt, and all or a portion of the payment must be reflected in the taxpayer's AFS in a year subsequent to the year of receipt. Further, the payments may only relate to certain items such as goods, services, the use of intellectual property, computer software, eligible gift cards, certain warranty contracts, subscriptions, memberships, and the occupancy or use of property ancillary to the provision of services.

Taxpayers with contracts allocated to multiple performance obligations under the new standards should examine the treatment of revenue attributable to each performance obligation to determine the potential existence of an advance payment eligible for deferral. For example, taxpayers offering loyalty programs may have a portion of their sales allocated to the loyalty points provided to a customer under the program. The regulations indicate that such an allocation may result in a deferral opportunity for the loyalty program revenue.

Procedural guidance

Implementation of the foregoing rules may prove to be almost as complex as the rules themselves. The IRS released Rev. Proc. 2021 - 34 , which modifies Rev. Proc. 2019 - 43 , to provide procedures to obtain automatic consent from the IRS to change methods of accounting to comply with the final rules under Regs. Secs. 1. 451 - 3 and 1. 451 - 8 . The revenue procedure itself is over 70 pages and contains extensive details relating to the multiple method changes available, concurrent filings, streamlined method change procedure, audit protection, netting of Sec. 481(a) adjustments, and waiver of the ineligibility rule triggered by changes in the prior five years. As such, taxpayers must carefully examine the revenue procedure for proper application of the final regulations, as it is nuance - driven and, therefore, creates the possibility for technical "foot faults" in its application. Some of the more significant procedural rules relate to the following:

• The procedures and rules included therein are effective for all Forms 3115, Application for Change in Accounting Method , filed with the IRS on or after Aug. 12, 2021.
• Streamlined method change procedures are available to taxpayers implementing certain methods provided for in the final regulations that compute zero Sec. 481(a) adjustment. Such procedures do not require a taxpayer to complete and attach a Form 3115 or statement to the tax return.
• Audit protection is generally provided for all Forms 3115 filed under the revenue procedure. However, taxpayers using the streamlined method change procedures will not receive audit protection.
• The five-year scope limitation under Section 5.01(f) of Rev. Proc. 2015-13 (which limits a taxpayer's ability to make automatic method changes if the taxpayer made a change for the same item in the prior five years) is waived for a taxpayer's early adoption year or, if there was no early adoption, for the taxpayer's first tax year beginning on or after Jan. 1, 2021. Thus, it appears that the five-year waiver may only be used once by a taxpayer when applying the final regulations.
• The revenue procedure adds seven new automatic method changes to the current list of automatic changes in Rev. Proc. 2019-43 and modifies several others. Taxpayers should review those modifications for any pending method changes and make adjustments to comply as necessary.

Implementing the final regulations

The following examples illustrate some of the decisions that taxpayers will need to make during implementation of the final regulations using the procedural rules of Rev. Proc. 2021 - 34 . For all examples it is assumed that the taxpayer is an accrual - method taxpayer with an AFS and is on a calendar year end for both tax and AFS.

Example 1: In December 2021, Taxpayer enters into a contract with its customer to manufacture and deliver goods in 2023, with a total contract price of $100, and receives an advance payment of $40. In its AFS, Taxpayer does not report any revenue in 2021 and will report the entire $100 in its 2023 AFS, the year of delivery. Taxpayer is currently on a permissible one - year deferral method under Rev. Proc. 2004 - 34 .

Analysis : Under its present method of accounting, Taxpayer would recognize no revenue for tax purposes in 2021 because it did not recognize any in its AFS. However, the entire $40 advance payment will be recognized in taxable income in 2022. Taxpayer may change to use the one - year deferral method under the final regulations, and it would have the same taxable income impact as under its present method of deferral. Alternatively, Taxpayer may change to use the full - inclusion method under the automatic procedures, and if it does, it would recognize the entire advance payment in its 2021 taxable income.

Observations : Whether Taxpayer decides to change to the full - inclusion method or stay on the deferral method, it is required to implement the final regulations in 2021 and must change from its present method of accounting. However, if Taxpayer decides to implement the deferral method under the final regulations, it may be eligible to do so under the streamlined procedures in Rev. Proc. 2021 - 34 because the Sec. 481(a) adjustment would be $0. Use of the streamlined procedures is optional, and Taxpayer may instead choose to make the change by filing a Form 3115. Taxpayer should be aware that if it uses the streamlined procedures, it does not receive audit protection for prior years. While not directly the subject of this example, Taxpayer is also incurring costs to which it could apply the advance payment cost - offset method (similar to Example 3), which would create an additional deferral of income.

Example 2: In July 2021, Taxpayer enters into a contract with its customer to provide professional services with a total contract price of $100, billable upon delivery, with an estimated cost to deliver of $60. The terms and conditions of the contract provide that if the customer cancels the contract, the customer is only required to pay Taxpayer the amount that it spent or incurred through the cancellation date. In its AFS, Taxpayer reports revenue from the contract over time. Additionally, Taxpayer has determined that it generally only collects 90% of the contract value from this type of contract and reduces its transaction price by 10% when computing its AFS revenue. Taxpayer incurs $30 of costs on the contract in 2021 and computes its AFS revenue to be $45, which is the total contract price, less the amount anticipated to be uncollectible, multiplied by the ratio of costs incurred over estimated total costs to deliver (($100 − $10) × ($30 ÷ $60)). For tax purposes, Taxpayer currently recognizes revenue equal to its AFS.

Analysis : Under the final regulations, Taxpayer may choose to use either the AFS income - inclusion rule or the alternative method to determine the amount of revenue to accelerate as AFS revenue under Sec. 451(b). If it chooses to use the general rule, then Taxpayer would increase the transaction price by the amount anticipated to be uncollectible, and it would reduce the transaction price by the amount to which it does not have an enforceable right. In this case, because the customer could cancel the contract on the last day of the year and would only be required to reimburse the $30, Taxpayer would adjust its 2021 taxable income to be $30 ($45 + $5 — $20) and have a favorable book - tax adjustment of $15. If Taxpayer instead implements the final regulations using the alternative method, it will only make an adjustment for the amount anticipated to be uncollectible and would recognize revenue of $50 for tax purposes in 2021 ($45 + $5) and an unfavorable book - tax adjustment of $5.

Observations : Taxpayer has a decision to make when implementing the final regulations: It may use either the AFS income - inclusion rule or the alternative method to determine its AFS revenue inclusion. On the surface, using the AFS income - inclusion rule and reducing revenue based on the enforceable rights adjustment may be beneficial (depending upon other tax attributes such as NOLs, credits, etc.) for Taxpayer because it results in lower revenue and taxable income. However, that benefit comes with the requirement that Taxpayer evaluate each contract at the end of each year to determine the amount to which it has an enforceable right — a challenging task if contracts are customized or voluminous. Taxpayer may find that the relative simplicity of the alternative method may be preferable, even though it is not the most tax - advantaged method. Under either scenario, Taxpayer will be required to make adjustments to AFS revenue to increase the transaction price by the amounts anticipated to be uncollectible.

Example 3: In 2021, Taxpayer enters into a contract with its customer to manufacture and deliver goods with a total contract price of $100, billable upon delivery. In its AFS, Taxpayer recognizes $11 of costs associated with the contract in 2021 and $47 in 2022. Taxpayer includes $20 in its AFS revenue in 2021. Taxpayer properly applies its inventory tax accounting methods and incurs $12 of costs for tax purposes in 2021 and $48 in 2022. Taxpayer implements the final regulations and chooses to adopt the cost - offset method beginning in 2021.

Analysis : Taxpayer reduces the $20 AFS inclusion amount by the $12 cost - of - goods - in - progress offset, which results in the recognition of $8 of revenue for tax purposes in 2021. Taxpayer is not entitled to a COGS deduction for tax purposes in 2021 because it retains title to the goods in 2021. Taxpayer receives the $100 upon delivery of the goods in 2022. This amount is reduced by the prior (2021) tax inclusion amount of $8, which results in the recognition of $92 of revenue for tax purposes in 2022. Taxpayer is entitled to a $60 COGS deduction for tax purposes in 2022, as ownership of the goods passed to the customer in 2022. The result to Taxpayer in 2022 is gross income for tax purposes of $32.

Observations : By electing to use the cost - offset method, Taxpayer was able to defer revenue of $12 (the cost - of - goods - in - progress offset) to 2022, which is a favorable outcome and mirrors closely (but not exactly) the computation of income for AFS purposes. However, the cost - offset method must be applied to all items of income eligible for the method in the taxpayer's trade or business and allocated on an item - by - item basis. Such computations may be difficult or time - consuming and even costly to Taxpayer. The use of the cost - offset method is optional, so Taxpayer may choose to simply recognize $20 of revenue in 2021, without the offset, to simplify its tax calculations.

Closing thoughts

The final regulations and associated procedural guidance are intricate and contain many options and choices for taxpayers, as well as traps for the unwary. With the current procedural guidance, most taxpayers have one chance in the year beginning on or after Jan. 1, 2021, to complete the analysis and take steps such as automatic method changes. Beginning a detailed analysis early will allow taxpayers the time and flexibility to make those choices and to perform complex computations or make required tax filings.

Editor Notes

Greg A. Fairbanks , J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or [email protected] .

Contributors are members of or associated with Grant Thornton LLP.

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