Lesson 1 of 9 · All lessons in this module
- Revenue recognition: core principle and the five-step model
- Revenue recognition in practice and what it means for analysisVideo lesson
- Expense recognition and capitalising versus expensing
- Capitalised interest and capitalised development costsVideo lesson
- Non-recurring items, discontinued operations and accounting changesVideo lesson
- Basic EPS and the weighted average number of sharesVideo lesson
- Diluted EPS: if-converted, treasury stock and antidilutionVideo lesson
- Common-size income statements and margin analysis
- Integrated cases: capitalising, restated results and gross versus net revenue
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Lesson 1 of 9 · 13 min
Revenue recognition: core principle and the five-step model
Revenue is recognised when control of a promised good or service passes to the customer, in the amount the seller expects to be entitled to, which need not coincide with when cash arrives.
In short
- Under accrual accounting, revenue is reported when it is earned, not when cash is received. Selling on credit creates a receivable; cash received before delivery creates a liability (deferred or unearned revenue).
- IFRS and US GAAP have converged standards. The core principle: recognise revenue to depict the transfer of promised goods or services, in the amount of consideration the seller expects to be entitled to.
- Five steps: (1) identify the contract, (2) identify the distinct performance obligations, (3) determine the transaction price, (4) allocate the price to the obligations, (5) recognise revenue when (or as) each obligation is satisfied.
- A contract exists only if collection is probable: 'more likely than not' under IFRS, 'likely to occur' under US GAAP, so similar contracts can be treated differently.
- Revenue that is likely to reverse (e.g. expected returns) is not recognised; a refund liability and a right to returned goods asset are recorded instead. Payment received in advance is a contract liability; revenue earned but conditional on further performance is a contract asset.
Earned, not collected
Accrual accounting separates the timing of revenue from the timing of cash. A sale is recorded when the seller has done what it promised, typically when the goods or services are delivered. If the customer pays later, the seller records a trade receivable; when the cash arrives, the receivable is simply settled and no new revenue arises.
The reverse happens when a customer pays up front. A gym that sells a one-year membership in January has received cash but has not yet provided the service. It records a liability, unearned (deferred) revenue, and recognises revenue month by month as it provides access.
Net revenue is gross sales less returns and allowances. Cash collected is irrelevant to the amount: a company that sells EUR 800,000 of goods, accepts EUR 50,000 of returns and collects EUR 600,000 reports net revenue of EUR 750,000 and still has EUR 150,000 to collect.
The five steps
The converged standard (issued by the IASB and FASB in 2014) is principles-based so it can be applied to almost any business. It works through five steps. Steps 3 and 4 decide how much revenue; step 5 decides when.
| Step | What it asks | Key points |
|---|---|---|
| 1. Identify the contract | Is there an enforceable agreement? | Commercial substance, each party's rights and payment terms defined, collection probable |
| 2. Identify performance obligations | What distinct promises were made? | A good or service is distinct if the customer can benefit from it on its own (or with readily available resources) and it is separable from the other promises |
| 3. Determine the transaction price | How much does the seller expect to receive? | An estimate; reflects expected collectability and possible returns |
| 4. Allocate the price | How much belongs to each obligation? | Each obligation is accounted for separately |
| 5. Recognise revenue | When is each obligation satisfied? | When (or as) control passes to the customer: at a point in time or over time |
The collectability threshold is worded identically in both frameworks but means different things: 'probable' is a lower bar under IFRS (more likely than not) than under US GAAP (likely to occur). Economically identical contracts may therefore be recognised under one framework and not the other.
Control, reversals and contract balances
Revenue is recognised when the customer obtains control. Indicators that control has passed include: the seller has a present right to payment, the customer has legal title, the customer has physical possession, the customer bears the significant risks and rewards of ownership, and the customer has accepted the good or service.
Revenue is recognised only to the extent that it is highly probable it will not be reversed later. If goods are likely to come back, the seller recognises only the revenue it expects to keep, plus a refund liability for the expected refunds and a right to returned goods asset (based on the inventory's carrying amount less costs of recovery).
Three balance sheet items can arise. If the obligation is satisfied and payment is unconditional, the seller records a receivable. If revenue is recognised but payment still depends on further performance, it records a contract asset until the receivable becomes unconditional. If the customer pays before the seller performs, it records a contract liability.
The standard also covers contract costs: the incremental costs of obtaining a contract (such as sales commissions) and certain costs of fulfilling it are capitalised and expensed later. A company that previously expensed these costs immediately will show higher initial profitability under the converged standard.
- Income, in the IFRS sense, comes from increases in assets, enhancements of assets or decreases in liabilities that are not contributions from owners. Revenue is the part that arises from ordinary activities.
- Disclosures are extensive: revenue disaggregated by category (product, region, customer type, contract type or duration, timing of transfer), contract asset and liability balances and their changes, remaining performance obligations, and significant judgements.
Formulas
- Net revenue
Cash collected does not enter the calculation; uncollected amounts sit in receivables.
- Allocating a bundled price (relative stand-alone selling prices)
A common way to perform step 4 when one contract contains several distinct obligations.
Worked examples
Example 1 Accrual revenue versus cash
In its first year, Brisa Textiles SL ships goods invoiced at EUR 800,000, accepts EUR 50,000 of returns and collects EUR 600,000 in cash. Cost of goods sold is EUR 520,000. What net revenue is reported, and what receivable remains?
Example 2 A bundle with two performance obligations
Halvorsen Fitness AS sells a rowing machine with a two-year service plan for a single price of NOK 30,000, paid up front at delivery on 1 January. Sold separately, the machine costs NOK 27,000 and the plan NOK 9,000. How much revenue is recognised in Year 1, and what contract liability remains at the end of Year 1?
Example 3 Which balance arises?
Classify each situation: (a) a software firm receives a full-year subscription fee before giving access; (b) an engineering firm has completed the first phase of a project, but the contract says it can only bill once phase two is finished; (c) a wholesaler delivers goods on 30-day credit terms.
On the exam
Expect the order and purpose of the five steps, the IFRS vs US GAAP meaning of 'probable', net revenue calculations with returns, and which balance (receivable, contract asset, contract liability) a situation creates.
- Treating cash collected as revenue. Revenue is earned; collection only settles a receivable.
- Confusing a contract asset (revenue earned, payment conditional) with a contract liability (cash received, performance outstanding).
- Thinking 'probable' means the same in both frameworks. IFRS: more likely than not; US GAAP: likely to occur.
- Recognising revenue on sales likely to be returned instead of recording a refund liability.
Check yourself
Q1In the five-step revenue model, which step determines the timing of revenue recognition?
Q2Under IFRS, the collectability threshold for a contract to exist ('probable') means:
Q3A retailer invoices GBP 1,200,000 of sales, accepts GBP 80,000 of returns and collects GBP 900,000. Net revenue on an accrual basis is closest to:
Q4A customer pays in full before the seller delivers anything. The seller most likely records:
Q5Under the converged standard, sales commissions that are incremental costs of obtaining a contract are most likely:
Answer the 5 questions: +10 XP for each one you get right first time.
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