Revenue recognition is a structured framework that impacts everything from a business’s financial statements to its credibility in the market. Many businesses use the five-step model, a systematic method for recognising revenue that provides stakeholders with a more transparent view of a company’s financial performance. In the US, the Accounting Standards Codification released in 2014, known as ASC 606, introduced this framework to create cohesion in revenue reporting across different industries. Since then, multiple amendments have clarified how businesses in the US may best adopt this revenue model. In 2018, publicly traded firms were required to adopt ASC 606 – a substantial change since only 30 US-listed firms (out of 3,397) had adopted the new standard before 2018.

In this article, we’ll explain the five-step model for revenue recognition, including the criteria that businesses must meet before revenue can be recognised and reflected in financial statements.

What’s in this article?

• What is revenue recognition?
  
• What is the five-step revenue recognition model?
  
• Challenges, solutions, and practical considerations
  
• How Stripe Revenue Recognition can help
  

What is revenue recognition?

Revenue recognition is the set of guidelines that stipulates when a company should record its income. These guidelines allow a company to identify the point at which a service has been provided or a product has been delivered, therefore allowing that revenue to be recorded on the books. The objective of revenue recognition is to provide a complete view of a company’s earnings and expenses over a specific period. This helps both internal decision-makers and external parties such as investors make informed judgments.

What is the five-step revenue recognition model?

Identify the contract with the customer

Step one is creating a binding agreement between the business and the customer. This agreement specifies the terms under which goods or services will be transferred. Whether it’s a formal written contract or an oral agreement, the primary condition is that both parties understand their respective obligations and rights.

• What businesses should do
  Businesses should carefully document the terms of the agreement, ensuring both sides understand and approve. Parties should pay careful attention to any conditions, such as payment terms or delivery schedules. The goal is to create a concrete reference point for both sides, minimising ambiguities that could cause issues later on.

• Impact
  A well-defined contract establishes the groundwork for all subsequent steps, making it easier to identify performance obligations, set transaction prices, and ultimately, recognise revenue. Faulty or unclear contracts can lead to accounting irregularities, causing problems with financial reporting and potentially resulting in regulatory scrutiny.

Identify performance obligations

Step two involves identifying all the individual tasks, services, or goods that the business is agreeing to provide to the customer as part of the contract. These are known as performance obligations. They should be distinct and separable, meaning each can be provided independently of the others.

• What businesses should do
  Companies should list all performance obligations in detail. This list serves as a roadmap for fulfilling the contract and is important for proper revenue recognition. Businesses should also consider whether some obligations are conditional on the fulfilment of others and document this relationship clearly.

• Impact
  Identifying performance obligations accurately is key for a reliable revenue recognition process because it lays the groundwork for the appropriate allocation of transaction prices in later steps. Mistakes or omissions can lead to inaccurate financial reporting, which could mislead stakeholders and potentially result in regulatory action.

Determine the transaction price

Step three is pinpointing the total amount that the company expects to earn for fulfilling its performance obligations. Complexities often arise due to elements such as time value of money, variability factors, and non-cash considerations.

• What businesses should do
  Businesses should consider different factors that might affect the final transaction price, such as trade discounts, volume rebates, and contingent amounts based on future events. Develop a comprehensive model that captures all these variables. For instance, when dealing with long-term contracts, companies should translate the transaction price to its present value to account for the time value of money.

• Impact
  Determining the accurate transaction price has far-reaching implications. Mistakes in this step may result in financial inconsistencies, potential restatements, and credibility issues with stakeholders. A well-calculated transaction price serves as the baseline for allocating resources and strategising for profitability. It sets the stage for how much revenue will eventually be recognised, influencing future business decisions and growth strategies.

Allocate the transaction price

Step four involves distributing the transaction price, established in step three, across the performance obligations identified in step two. The allocation should reflect the amount the company expects to earn for each distinct obligation, which can demand nuanced financial modelling and estimates.

• What businesses should do
  Companies should use both qualitative and quantitative analyses to find stand-alone selling prices for each performance obligation. Advanced techniques such as Monte Carlo simulations can help businesses estimate stand-alone prices in situations where market conditions are volatile or when there are no observable inputs. For long-term contracts that involve multiple goods or services, changes in allocation can occur over the contract term due to factors such as modifications or penalties. Businesses should have internal controls and regular reviews in place to manage these variables.

• Impact
  Incorrect allocations can distort profit margins and paint a misleading picture of the profitability within different business lines or products. This could result in poorly informed strategic decisions. More immediately, missteps in this stage could lead to a breach of contract covenants or could trigger compliance issues, especially in regulated industries.

Recognise revenue when (or as) the entity satisfies a performance obligation

Step five is when revenue is finally recognised in the financial statements. The timing and amount are contingent upon fulfilling the performance obligations previously identified. The focus is on transferring control – either over time or at a particular point in time – of the good or service to the customer.

• What businesses should do
  Accounting and operations teams should collaborate to track the completion of performance obligations. Advanced metrics or key performance indicators are one way to show that control has been transferred. Companies can employ escrow arrangements or rely on third-party confirmations as safeguards, to ensure revenue is not recognised prematurely. Businesses must also have a robust audit trail for verification purposes, especially for contracts that span multiple reporting periods.

• Impact
  Recognising revenue has far-reaching implications for financial ratios, investor relations, and executive compensation linked to revenue targets. Missteps at this stage can invite regulatory scrutiny and jeopardise relationships with financial institutions, especially if they lead to material adjustments in subsequent periods. Lastly, how revenue is recognised influences both the timing and amount of tax liabilities, adding another layer of complexity and potential risk.

Challenges, solutions, and practical considerations

Issues businesses often face around revenue recognition

• Multiple terms in agreements: Different clauses and stipulations, especially in contracts that have a long time frame, make it difficult to determine what is owed to whom and when. This creates a ripple effect on the steps that follow, such as pinning down the true price of the deal and how much revenue should be claimed at what time.
  
• Bundled products or services: When a single deal includes a mix of goods and services, breaking down the total deal cost into individual parts can be a complicated process, and sometimes the results must be revised.
  
• Adaptation of new standards: If you need to make sweeping changes to internal processes due to new or revised revenue accounting guidelines, you may face resistance at multiple levels within a business. This can lead to delays and elevated costs.
  
• Collection and storing of information: It can be an intricate process to collect accurate data in real time for what is owed in a contract, or for any adjustments to the agreed-upon price – especially for companies not equipped with specialised software.
  
• Legal and financial repercussions: Missteps can lead to financial penalties and loss of market trust.
  

Methods to overcome these challenges

• Uniform agreements: Use standardised agreement formats to simplify the first steps – figuring out what is owed and its price. While each agreement may require adjustments, a standard format is a good starting point.
  
• Automated accounting solutions: There are specialised software options that can automatically break down costs, track completion stages, and generate reports – thereby lifting a significant burden off of the finance team.
  
• Collaborative effort: If an issue arises, the accounting, operations, and legal divisions should work together to come up with a plan of action.
  
• Frequent training programmes: Keep the team up-to-date on current rules and guidelines by organising regular learning sessions. These can also serve as a refresher for long-standing policies.
  
• Third-party reviews: A third-party review can act as a valuable final check, spotting inconsistencies or errors that you and your team might have overlooked.
  

Considerations to bear in mind

• Recordkeeping: Documentation is an important best practice that keeps information transparent while making internal evaluations more insightful.
  
• Safeguarding data: Given the sensitive nature of contracts and pricing data, as well as other information that may be included in transactions, businesses must employ strong data safety protocols.
  
• Deadlines: Having a set schedule for each stage of revenue recognition can help you avoid last-minute rushes and errors, making the year-end financial closing a smoother process.
  
• Tax planning: Businesses must consider the tax consequences of how and when revenue is recognised. This helps to avoid unexpected tax bills and optimises tax status.
  
• Resource planning: Businesses should consider what resources they will require, including labour and technology, to avoid any bottlenecks in the revenue recognition process.
  

Taking these considerations into account can help companies develop a more dependable method for revenue recognition.

How Stripe Revenue Recognition can help

Stripe Revenue Recognition helps to streamline accrual accounting – including audits, end-of-month close, reporting, and more – so you can close your books with greater efficiency and accuracy. It automates and configures revenue reports to help support compliance with ASC 606 and IFRS 15.

Revenue Recognition can help you:

• Gain a more complete view of your revenue: In the Stripe Dashboard, see all your Stripe transactions and terms, and import non-Stripe data.
  
• Automate revenue reports: Generate accounting reports that are ready to use – without engineering resources.
  
• Customise for your business: Create and automate custom rules to recognise revenue, in line with your business’s accounting practices.
  
• Audit in real time: Prepare for audits by tracing any revenue amount down to the underlying customers and transactions.
  

Read our guide to learn how Revenue Recognition can help you comply with global accounting principles, or get started today.