Revenue Recognition

Revenue recognition is the accounting principle, and the detailed rules behind it, that decide when a business records revenue and how much. The core idea is that revenue is recognised when the business has done what it promised the customer, by transferring goods or services, not simply when an invoice is raised or cash arrives. Revenue is usually the largest number in a company's income statement, so the timing rules matter to investors, lenders, auditors and tax authorities.

Today the main rules are IFRS 15 Revenue from Contracts with Customers, issued by the International Accounting Standards Board, and ASC 606, the matching US GAAP standard issued by the Financial Accounting Standards Board. The two boards published them together in May 2014 as a largely converged standard. Revenue recognition is a central part of accrual accounting and does not apply in the same way under cash accounting.

Imagine you pay a gym $600 in January for a year's membership. The gym has your cash on day one, but it has not yet given you a year of access. It earns the money a little at a time, one month of workouts at a time, so it counts $50 as earned each month.

Now imagine you buy a bicycle and walk out with it. The shop has done everything it promised the moment you leave, so it counts the whole price as earned that day. Revenue recognition is the rulebook that tells businesses which of these patterns applies to each thing they sell.

IFRS 15 and ASC 606 apply the same five steps to contracts with customers:

1. Identify the contract. An agreement that creates enforceable rights and obligations, with commercial substance and probable collection.
2. Identify the performance obligations. Each distinct good or service promised, such as a device, installation and a year of support.
3. Determine the transaction price. The amount the business expects to be entitled to, adjusted for discounts, rebates, refunds and other variable amounts.
4. Allocate the price. Split the price across the performance obligations in proportion to their standalone selling prices.
5. Recognise revenue as each obligation is satisfied. Either at a point in time, when control passes, or over time, as the service is delivered.

Step 4 uses the relative standalone selling price:

Here $\text{SSP}_i$ is the price at which the business would sell obligation $i$ on its own, and the sum runs over all obligations in the contract. Example: a phone (standalone price $600) and a 12-month service plan (standalone price $400) are sold together for $800. The phone gets $800 \times 600 / 1{,}000 = 480$ and the plan gets $800 \times 400 / 1{,}000 = 320$. The $480 is recognised when the customer takes the phone; the $320 is recognised at about $26.67 a month over the year, with the unearned part held as deferred revenue.

IFRS 15 applies to annual periods beginning on or after 1 January 2018. ASC 606 applied to US public business entities for annual periods beginning after 15 December 2017, and to private companies and most other entities from later dates. Before them, IFRS relied on IAS 18 and IAS 11, while US GAAP had many industry-specific rules; the new standards replaced these with one model for all industries. Some areas sit outside them, such as leases, insurance contracts and financial instruments, which have their own standards.

Several issues come up repeatedly for payment companies, card issuers and platforms:

• Principal or agent. A firm that controls a good or service before it reaches the customer reports revenue gross; one that only arranges it for another party reports net. A payment processor collecting a merchant's full sale but keeping only a fee must decide which applies, and the answer can change reported revenue many times over even though net income is the same. Treatment of pass-through costs such as interchange and scheme fees depends on this judgement.
• Subscriptions. Software and service subscriptions are generally recognised over the subscription term; metrics such as monthly recurring revenue are management figures, not GAAP revenue.
• Variable consideration. Volume rebates, expected refunds and expected chargebacks reduce the transaction price, subject to a constraint that revenue should not be recognised if a large reversal is likely.
• Breakage. Gift cards and stored value that customers never use are recognised as revenue in proportion to expected usage, a subject covered under gift card breakage.

Revenue rules involve estimates, such as standalone prices and progress on long contracts, so the standards require detailed disclosures, including disaggregated revenue and opening and closing contract balances. Revenue is also one of the most common areas of financial reporting fraud: recording sales too early, booking sales that never happened, or shipping goods in advance to inflate a period. An independent auditor therefore treats revenue recognition as a presumed fraud risk, and finance teams review it closely during the financial close before it reaches the financial statements and wider financial reporting.

• IFRS Foundation: IFRS 15 Revenue from Contracts with Customers