When should revenue be recognized in a given transaction? This really should not be rocket science, but apparently it is. It’s also an example of how regulations get created because some Tricky Dick Accountants. Lawyers, Salespeople or Executives decide that gaming the system is to be preferred over the reality. Revenue recognition – pure and simple – is the accounting recording of either the increase in the value of an asset or the decline in the value of a liability (or some combination of both) as the consequence of a product or service transaction.
It’s not carved in concrete though. Revenue could be recognized either before or after the delivery of an actual transaction in instances such as a contingency contractual arrangement, a bill and hold transaction, an installment sale or a multi-element software sales agreement. In each case, the percentage or partial transaction should define the parallel partial revenue recognized. You don’t get credit for 100% of the revenue if only 2% of the software has been delivered and accepted by the customer.
Revenue recognition really becomes an accounting problem when management or executives “rig” the system for their personal benefit. How many different ways are there to do this? Many, it seems.
- Shipment or transfer of assets to third parties, resellers, or company-owned facilities, while in fact retaining ownership, but counting revenue as if actually sold to customers.
- Accounting for assets sold, but products/services transferred are partial, incomplete, have a right-to-return, or contractual commitments have not yet been fully performed.
- Creation of fictitious accounts, customers, resellers or transactions.
- Double billings, re-invoicing past-due receivables, or otherwise inflating transactions – existing or non-existent.
- Artificial billings based on future sales – real or otherwise.
- Recording additional sales invoiced and shipped after the end of a reporting period.
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have come together to propose a new regulation and definition of revenue recognition. Interestingly enough, they both agree that a new accounting standard is needed to simplify and reconcile the differences between U.S. Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS).
The new “core principles” for revenue recognition are pretty straight-forward:
Step 1. Identify contract(s) with the customer
Step 2. Identify separate performance obligations.
Step 3. Determine transaction price.
Step 4. Allocate transaction price to each performance obligation.
Step 5. Recognize revenue when each performance obligation is satisfied.
This is a case where the proposed standard actually is simpler and less confusing than the existing criteria with their numerous variations by industry, geography, and contract. But, let’s see how much wailing and whining the new standard generates, in spite of its obvious principle-based simplicity.