By The Books: Understanding The New Five-Step Revenue Recognition System

If you're beginning your new career as a financial planner for a business or organization, you might not be prepared for the changes that have been taking place when it comes to revenue recognition. Prior to the changes, there are several different revenue recognition programs available. Unfortunately, those differences tended to create a lot of confusion in the business world. To streamline the revenue recognition process, a standard system was designed. This five-step system gets rid of the confusion. Here's how the five-step revenue recognition system works.

Know the Contract

The first step of the new system is quite basic. It involves the implementation of a contract. In order for a contract to exist, there needs to be three parts, which include:

• Commercial substance
• Identifiable promise of goods and services
• Agreement of payment terms

Understand Each Obligation

When it comes to a contract, it's important to understand each separate obligation, as it relates to the contract. When you enter into a contract for goods and services, everything isn't combined into one obligation. Each section of the contract requires its own obligation.  For instance, if you've entered into a contract to sell, and the client added installation and a warranty to the desired services, the purchase, installation, and warranty would be handled as three separate obligations.

Identify the Transaction Cost

The transaction cost is an important aspect of your business revenue. This is not to be confused with the basic cost of the service you're providing. The transaction cost takes into consideration the actual cost of performing a particular service. Your transaction cost should include the actual cost of the service, plus the variable costs of time, manpower, etc.

Set Transaction Costs for Each Obligation

Once you've set the transaction cost for the main portion of the contract, you'll need to set the transaction costs for each separate obligation. This will ensure that your records show the value of the complete transaction history. The reason for the separate transaction costs is that each portion of the contract is an individual obligation.

Enter Revenue After Obligation is Met

Unlike debt that is entered onto the books as soon it's incurred, revenue is not recognized in the books until the obligation has been met. If the services your company provides requires extended contract time to perform the obligations, you'll enter the revenue as it's paid. This will allow you to keep a running transaction history of each contract obligation.