The 5 Step Approach To Revenue Recognition

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The Financial Accounting Standards Board (FASB) issued Revenue from Contracts with Customers (Topic 606) to clarify and apply revenue recognition principles consistently across industries. The guidance establishes a five step process that outlines how financial statement users should report the nature, amount, and timing of revenue from contracts with customers. The standard will go into effect for nonpublic entities with fiscal years beginning after Dec. 15, 2018. Early adoption is allowed.

What is revenue recognition?

Revenue recognition shows the transfer of promised goods or services in an amount that reflects how a business expects to be compensated. To comply with Topic 606, every business must follow these five steps:

  1. Identify the contract with the customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue when, or as, the entity satisfies a performance obligation

Step 1: Identify the contract with the customer

The contract can be written, verbal, or implied and is based on your company's ordinary practices. The contract should outline payment terms and any other rights of your business and the customer related to the goods or services that will be transferred.  

Step 2: Identify the performance obligations in the contract

Once you've established the contract, identify each promise you make to the customer - aka the performance obligation. A performance obligation is a distinct good or service, or a series of distinct goods or services, that are substantially the same and have the same pattern of transfer to the customer.  

Step 3: Determine the transaction price

The contract may include fixed consideration, variable consideration, or both types. If it includes variable consideration, estimate the amount of variable consideration you're entitled to. You can use the expected value method or most likely amount method to calculate this amount. Pay attention to the timing of the payment and how much time will pass between the transfer of promised goods and services and when the customer pays to determine if there is a financing component. If a significant amount of time passes, adjust the transaction price for the time value of money.  

Step 4: Allocate the transaction price to the performance obligations in the contract

Assign a price to each performance obligation in the contract. Base the prices on relative standalone selling prices like the sale of similar goods or services, a contractually stated price, or a list price. If you can't directly observe a standalone selling price, you can estimate the price using one of these methods: adjusted market assessment, expected cost plus margin, or residual.  

Step 5: Recognize revenue when, or as, the entity satisfies a performance obligation

You'll either recognize revenue over time or at a point in time. If recognizing revenue over time, apply a single method of measuring progress for each performance obligation. Apply this method to any similar performance obligations and remeasure the progress at the end of each reporting period. You can recognize revenue at a point in time if the performance obligation doesn't meet the criteria to recognize revenue over time. The performance obligation is met at the most practical point in time when the customer gains control of the asset.   Though the FASB guidance seeks to simplify the process of recognizing revenue, a thorough understanding of the new standardis key for successful adoption and reporting. The five steps outlined above provide a general overview and description of each step. Consult with an accounting professional to ensure you understand the requirements, responsibilities, and details of each step. Originally published 6/13/2018. Updated 10/6/2021.

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Carol Hubbard
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Carol Hubbard is a Principal at Doeren Mayhew with nearly 40 years of experience in public accounting.

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