Revenue recognition and deferred revenue

September left a promise on the balance sheet. A customer paid $3,000 for a dozen drills, and Northwind booked it as deferred revenueFoundationsDeferred revenueConsideration received, or unconditionally due, before the goods or services are transferred — a liability until the performance obligation is satisfied. ASC 606 calls it a contract liability, a liability, because the drills were still on the shelf. October is when that promise is kept, and when Northwind signs its first contract with two promises in it. Both are revenue recognitionRevenue recognitionRevenue recognitionDeciding when, and how much, revenue is recorded — under US GAAP, when (or as) control of a promised good or service transfers to the customer, at the consideration the entity expects to be entitled to, and in the United States the rule for it is ASC 606Revenue recognitionASC 606Topic 606, Revenue from Contracts with Customers — five steps: identify the contract, identify the performance obligations, determine the transaction price, allocate it, recognize revenue as each obligation is satisfied.

The standard turns that one principle into five steps, applied to every contract with a customer. Most of the time the five take a second, because a sale over the counter answers all of them at once. They earn their keep when a contract bundles things, runs over time, or has a price that can move.

A contractRevenue recognitionContract with a customerAn agreement that creates enforceable rights and obligations — written, oral or implied by customary practice — accounted for under Topic 606 only once it is approved, each party's rights and the payment terms can be identified, it has commercial substance and collection is probable is an agreement that creates enforceable rights and obligations. It can be written, spoken or implied by how a business normally trades. ASC 606 only starts counting once five things are true: both sides approved it and are committed, each side's rights can be identified, so can the payment terms, it has commercial substance, and it's probable Northwind will collect what it's owed.

Each distinct good or service promised is a performance obligationRevenue recognitionPerformance obligationA promise in a contract to transfer a distinct good or service, or a series of substantially the same ones — the unit revenue is recognized by, the unit revenue is recognized by. A promise is distinct if the customer can benefit from it, on its own or with resources readily available to it, and it's separately identifiable from the other promises in the contract. The contractor could use the kit without the servicing, and Northwind sells servicing by itself, so this contract has two obligations, not one. The standard uses almost this case as its own illustration: an asset can transfer while a separate promise to maintain it is still owed.

Dr Accounts receivable 6,000
   Cr Revenue 6,000

Kit: revenue on delivery
Servicing: deferred, earned $125 a month

The transaction priceRevenue recognitionTransaction priceThe consideration an entity expects to be entitled to for the contract, including estimated variable consideration and excluding amounts collected for third parties such as sales tax is what Northwind expects to be entitled to: $6,000, fixed. A price that can move, through a rebate, a refund right, a usage fee or a bonus, is variable considerationRevenue recognitionVariable considerationAny part of the price that can change — discounts, rebates, refunds, credits, usage, bonuses, penalties — estimated and included only to the extent a significant reversal is not probable: estimated, and included only to the extent a significant reversal of revenue is not probable. Sales tax collected for the state stays out of it, as lesson 5 set up. And if Northwind were only arranging a sale another company fulfilled, principal versus agentRevenue recognitionPrincipal versus agentWhether the entity controls a good or service before it passes to the customer — a principal reports revenue gross, an agent reports only its fee or commission net would decide whether it reports the whole price or only its fee.

The price is shared across the obligations in proportion to their standalone selling pricesRevenue recognitionStandalone selling priceThe price at which an entity would sell a good or service separately — the basis for allocating the transaction price across performance obligations, so the discount is shared out too instead of landing on whichever line someone picks.

A promise is kept either over time or at a point in time. Over-time recognitionRevenue recognitionOver-time recognitionRecognizing a performance obligation's revenue as it is satisfied, measured by progress — required when the customer receives and consumes the benefit as the entity performs, controls the asset as it is built, or the asset has no alternative use and the entity has an enforceable right to payment to date applies when one of three tests is met, and servicing meets the first: the contractor gets the benefit of each month's sharpening as it's done. So the $1,500 is earned month by month, $125 at a time. The kit fails all three, so it's recognized at a point in timeRevenue recognitionPoint-in-time recognitionRecognizing a performance obligation's revenue on the date control passes, judged by indicators: a present right to payment, legal title, physical possession, the risks and rewards of ownership, acceptance, the day control passes. Northwind has the right to payment, the contractor has the kit, title and the risk of losing it, so that day is October 1.

OCT-2 is worth a second look. Invoicing the whole year up front gave Northwind an unconditional right to $6,000, a receivable, before it had done the servicing. The standard's answer is to show both: the receivable, and a contract liability for the work still owed. The reverse case, revenue earned before the right to bill is unconditional, is a contract assetRevenue recognitionContract assetRevenue recognized ahead of an unconditional right to payment — the right still depends on something other than the passage of time, and the simpler case where only time stands between Northwind and payment is the unbilled receivableRevenue recognitionUnbilled receivableRevenue recognized where the right to payment is unconditional but the invoice has not yet been issued — a receivable, not a contract asset from lesson 8.

In this lesson: the deferred revenue balance these entries leave behind, rolled forward through October, has its own page below.