Getting paid sounds simple—until it’s not.
You’ve got contracts, deliverables, and a whole lot of gray areas when it comes to recognizing revenue. One small mistake, and your financials could be off, your compliance in question, and your team chasing numbers that don’t add up.
But here’s the good news: There’s a clear system that can keep things on track.
Most companies either skip steps or rush through them. And that’s where things go wrong. If you want to avoid the common traps and handle revenue recognition with confidence, there’s a framework that brings structure—and clarity—to the chaos.
Why It’s Important to Follow All Five Steps in Revenue Recognition
Companies are supposed to follow five important steps in order when reviewing a contract under revenue recognition rules. But not every step applies in all situations. For example, if a company finds only one performance obligation in Step 2, then Step 4 (splitting the price between multiple tasks) may not be needed. In that case, they can skip from Step 3 straight to Step 5.
Still, the general rule is to go step by step:
The 5 Steps of Revenue Recognition
- Identify the Contract – Check if there’s a clear agreement with the customer that meets specific rules.
- Identify the Performance Obligations – Figure out what goods or services the company has promised to deliver.
- Determine the Transaction Price – Work out how much the company expects to be paid.
- Allocate the Transaction Price – Split the total amount between the different promised goods or services.
- Recognize Revenue – Record revenue when the company delivers what it promised.
Even though these steps are meant to be followed in order, sometimes, later steps affect earlier ones. For example, Step 3 (price) may help confirm if a contract even exists in Step 1. Or Step 5 might help clarify what counts as a performance obligation in Step 2. So, companies may have to jump back and forth to get things right based on the details of each contract.
Step 1 – Identifying the Contract
A contract with a customer is only valid if:
- Both sides have agreed (in writing, verbally, or through usual business practices).
- Both sides know what goods or services are involved.
- The payment terms are clear.
- The deal will likely affect the company’s future cash flow.
- It’s likely the company will get paid.
Step 2 – Identifying Performance Obligations
Companies must figure out what promises they’ve made in the contract. Missing any could affect when revenue is recorded. This process, sometimes called “unbundling,” means separating each task or item the company agreed to deliver.
However, if breaking things down doesn’t change how or when revenue is recorded, detailed unbundling may not be needed. For example, if multiple items are delivered together and treated as one task, unbundling might not be useful. Companies need to look closely and ask the right questions to identify each obligation correctly.
Step 3 – Determining the Transaction Price
This is the total amount a company expects to be paid for its goods or services. It doesn’t include money collected for others (like sales tax) and may include both fixed and variable parts.
To calculate this, the company should look at the contract terms and past practices. Some important things to consider include:
- Variable payments (e.g., bonuses or penalties)
- Limits on how much of the variable amount can be counted
- If the contract has a financing part (e.g., payments over time)
- Non-cash payments
- Any money the company has to give back to the customer
The customer’s credit risk shouldn’t affect the price calculation, unless the contract has a major financing part and you need to figure out a discount rate.
Step 4 – Allocating the Transaction Price
Once you have the total transaction price, you need to split it between the different tasks or promises in the contract. This is based on the regular selling price of each item or service.
Adjust the amounts if there are discounts or variable pricing involved.
Step 5 – Recognizing Revenue
Revenue is recorded when the company completes its part of the deal—delivering goods, services, or assets and giving control of them to the customer.
At the start, the company must decide if it’s going to fulfill the contract over time (e.g., a subscription) or at a single point in time (e.g., delivering a product).
Revenue is now recognized based on when control is passed to the customer—not just when risk or ownership changes. This new approach may not always change the timing of revenue, but in some cases, it will. That’s why it’s important to evaluate each case carefully.
Don’t Let Revenue Slip Through the Cracks
Revenue recognition may sound straightforward, but one misstep can send your financials into chaos. It’s like walking a tightrope—one wrong move, and the balance is off. The five-step framework is your safety net, but only if you follow it carefully, without shortcuts. Skipping a step or rushing can lead to mistakes that could haunt you later.
Every contract tells its own story, and without paying attention to the details, you’re leaving money on the table. When you break down the process, you’ll not only avoid costly errors but also gain clarity in your finances.
So, take a step back, follow the framework, and make sure you’re not missing a thing. The clarity and control you need to get paid accurately are right in front of you—don’t wait until it’s too late.
FAQs
In general, when is revenue recognized?
In general, revenue is recognized when a company delivers goods or services to a customer and the customer gains control over the asset. This usually occurs at a point in time or over time, depending on the terms of the contract and the nature of the deliverable.
What are the different revenue recognition methods?
There are various revenue recognition methods, such as the completed contract method, percentage-of-completion method, and the new rules under ASC 606, which require companies to recognize revenue based on the transfer of control to the customer, either at a single point in time or over a while.
What is the expense recognition principle?
The expense recognition principle, also known as the matching principle, dictates that expenses should be recognized in the same period as the revenues they help generate. This ensures that financial statements reflect an accurate representation of profitability.
How are trade discounts recognized?
Trade discounts are recognized when the sale is made and the transaction is recorded at the discounted price. Unlike sales returns or allowances, trade discounts are typically deducted from the list price before the revenue is recognized.