# Revenue recognition and deferred revenue

> The five steps of ASC 606, run on Northwind's October: a deposit earned on delivery, and a bundle split into a kit sold today and servicing earned month by month.

Source: https://lopifi.com/learn/revenue-recognition-and-deferred-revenue
Part of: Lopifi — US GAAP books on autopilot, checked by a CPA (https://lopifi.com)

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**How does revenue recognition work under ASC 606, and what is deferred revenue?** The five steps of ASC 606, run on Northwind's October: a deposit earned on delivery, and a bundle split into a kit sold today and servicing earned month by month.

September left a promise on the balance sheet. A customer paid $3,000 for a dozen drills, and Northwind booked it as [deferred revenue](https://lopifi.com/md/glossary/deferred-revenue), 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 recognition](https://lopifi.com/md/glossary/revenue-recognition), and in the United States the rule for it is [ASC 606](https://lopifi.com/md/glossary/asc-606).

> “The core principle of this Topic is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”

© Financial Accounting Foundation. All rights reserved.

— [ASC 606-10-05-3, -05-4; 606-10-25-23, -25-30](https://asc.fasb.org/606/tableOfContent), Revenue from Contracts with Customers — the core principle, and recognition when control transfers

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.

1. Contract (Approved, enforceable, collectible) → 2. Promises (A kit, and a year of servicing) → 3. Price ($6,000, fixed) → 4. Allocate (By standalone selling price) → 5. Recognize (Kit on delivery; servicing monthly)

The five steps, run on Northwind's October 1 contract.

> “An entity recognizes revenue in accordance with that core principle by applying the following steps: a. Step 1: Identify the contract(s) with a customer … b. Step 2: Identify the performance obligations in the contract … c. Step 3: Determine the transaction price … d. Step 4: Allocate the transaction price to the performance obligations in the contract … e. Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation”

© Financial Accounting Foundation. All rights reserved.

— [ASC 606-10-05-4](https://asc.fasb.org/606/tableOfContent), The five steps of Topic 606

**Northwind — A kit and a year of servicing, one price.** On October 1 a contractor signs for a professional tool kit and twelve months of servicing (sharpening and calibration, once a month) at one price of $6,000, invoiced on delivery and due in 30 days. Northwind sells both on their own: the kit for $5,400, a year of servicing for $1,800. Bought separately they come to $7,200, so the bundle carries a $1,200 discount.

## Step 1: is there a contract?

A [contract](https://lopifi.com/md/glossary/contract-with-a-customer) 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.

> “An entity shall account for a contract with a customer that is within the scope of this Topic only when all of the following criteria are met:”

© Financial Accounting Foundation. All rights reserved.

— [ASC 606-10-25-1](https://asc.fasb.org/606/tableOfContent), Step 1 — when an agreement is a contract the Topic applies to

> **Cash before a contract.** If a customer pays before those five criteria are met, the cash is not revenue. It sits as a liability until the contract qualifies.

## Step 2: how many promises?

Each distinct good or service promised is a [performance obligation](https://lopifi.com/md/glossary/performance-obligation), 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.

**Wrong:** Dr Accounts receivable 6,000
   Cr Revenue 6,000

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

Booking a bundle as one sale puts a year of service into the day it was signed. Revenue is then overstated in October and understated for the eleven months the work is actually done.

## Step 3: the transaction price

The [transaction price](https://lopifi.com/md/glossary/transaction-price) 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 consideration](https://lopifi.com/md/glossary/variable-consideration): 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 agent](https://lopifi.com/md/glossary/principal-versus-agent) would decide whether it reports the whole price or only its fee.

## Step 4: allocate the price

The price is shared across the obligations in proportion to their [standalone selling prices](https://lopifi.com/md/glossary/standalone-selling-price), so the discount is shared out too instead of landing on whichever line someone picks.

| Promise | Standalone price | Share | Allocated |
| --- | --- | --- | --- |
| Tool kit | 5,400 | 75% | 4,500 |
| Servicing, twelve months | 1,800 | 25% | 1,500 |
| Total | 7,200 |  | 6,000 |

Step 4, penny-exact. The parts sum to the contract price.

> “To allocate the transaction price to each performance obligation on a relative standalone selling price basis, an entity shall determine the standalone selling price at contract inception of the distinct good or service underlying each performance obligation in the contract and allocate the transaction price in proportion to those standalone selling prices.”

© Financial Accounting Foundation. All rights reserved.

— [ASC 606-10-32-31](https://asc.fasb.org/606/tableOfContent), Step 4 — allocate the price by relative standalone selling price

**Exercise — Allocate the transaction price.** The contractor pays $6,000 for the kit and a year of servicing together. Northwind sells each one on its own at the standalone prices shown. Allocate the contract price to each promise. Type it in the workbook at https://lopifi.com/playground.

## Step 5: when each promise is kept

A promise is kept either over time or at a point in time. [Over-time recognition](https://lopifi.com/md/glossary/over-time-recognition) 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 time](https://lopifi.com/md/glossary/point-in-time-recognition), 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.

> “An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met: a. The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs …”

© Financial Accounting Foundation. All rights reserved.

— [ASC 606-10-25-27](https://asc.fasb.org/606/tableOfContent), Step 5 — when a performance obligation is satisfied over time

> “In addition, an entity shall consider indicators of the transfer of control, which include, but are not limited to, the following: a. The entity has a present right to payment for the asset … b. The customer has legal title to the asset … c. The entity has transferred physical possession of the asset … d. The customer has the significant risks and rewards of ownership of the asset … e. The customer has accepted the asset”

© Financial Accounting Foundation. All rights reserved.

— [ASC 606-10-25-30](https://asc.fasb.org/606/tableOfContent), Step 5 — the indicators that control has passed at a point in time

*[Figure: revenue recognition]*

The October 1 contract through all five steps, at Northwind's own figures: $6,000 allocated by standalone price, the kit at a point in time and the servicing evenly over twelve months.

## The entries

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 asset](https://lopifi.com/md/glossary/contract-asset), and the simpler case where only time stands between Northwind and payment is the [unbilled receivable](https://lopifi.com/md/glossary/unbilled-receivable) from lesson 8.

> “A contract liability is an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or an amount of consideration is due) from the customer.”

© Financial Accounting Foundation. All rights reserved.

— [ASC 606-10-45-2](https://asc.fasb.org/606/tableOfContent), Deferred revenue is a contract liability

> **Revenue follows the promise, not the invoice and not the cash. Find the promises, price each one, and earn each when it's kept.**

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

## Pages in this lesson

- [Deferred revenue, rolled forward](https://lopifi.com/md/learn/revenue-recognition-and-deferred-revenue/deferred-revenue-roll-forward) — 4 min. How do you roll forward deferred revenue?

## Where this lesson's rules come from

- [ASC 606-10-05-3, -05-4; 606-10-25-23, -25-30](https://asc.fasb.org/606/tableOfContent) — Revenue from Contracts with Customers — the core principle, and recognition when control transfers (codification)
- [ASC 606-10-05-4](https://asc.fasb.org/606/tableOfContent) — The five steps of Topic 606 (codification)
- [ASC 606-10-25-1](https://asc.fasb.org/606/tableOfContent) — Step 1 — when an agreement is a contract the Topic applies to (codification)
- [ASC 606-10-32-31](https://asc.fasb.org/606/tableOfContent) — Step 4 — allocate the price by relative standalone selling price (codification)
- [ASC 606-10-25-27](https://asc.fasb.org/606/tableOfContent) — Step 5 — when a performance obligation is satisfied over time (codification)
- [ASC 606-10-25-30](https://asc.fasb.org/606/tableOfContent) — Step 5 — the indicators that control has passed at a point in time (codification)
- [ASC 606-10-45-2](https://asc.fasb.org/606/tableOfContent) — Deferred revenue is a contract liability (codification)
- [ASC 606-10-32-2A](https://asc.fasb.org/606/tableOfContent) — Sales taxes collected may be excluded from the transaction price — a policy election (codification)
- [Wikipedia, “Revenue recognition”](https://en.wikipedia.org/wiki/Revenue_recognition) — Revenue recognition (reference)
- [Wikipedia, “Deferral”](https://en.wikipedia.org/wiki/Deferral) — Deferral (reference)

## Read further

- https://lopifi.com/md/journal-entries/deferred-revenue
- https://lopifi.com/md/journal-entries/customer-deposit
- https://lopifi.com/md/journal-entries/bundled-contract-asc-606
- https://lopifi.com/md/journal-entries/sale-on-account
- https://lopifi.com/md/differences/deferred-revenue-vs-accrued-revenue
- https://lopifi.com/md/differences/accrual-vs-deferral
- https://lopifi.com/md/startups/revenue-recognition-for-saas-contracts
- https://lopifi.com/md/startups/deferred-revenue-for-saas
- https://lopifi.com/md/startups/mrr-vs-gaap-revenue
- https://lopifi.com/md/accounting/asc-606
- https://lopifi.com/md/accounting/deferred-revenue
- https://lopifi.com/md/tools/allocate
- https://lopifi.com/md/tools/amortize
- https://lopifi.com/md/docs/domain/04-schedules-and-accruals
- https://lopifi.com/md/docs/domain/05-order-to-cash

- **Track:** [Accounting](https://lopifi.com/md/learn/accounting)
- **Lesson:** Lesson 14 of 17 — 12 min
- **Terms taught:** [Revenue recognition](https://lopifi.com/md/glossary/revenue-recognition), [ASC 606](https://lopifi.com/md/glossary/asc-606), [Contract with a customer](https://lopifi.com/md/glossary/contract-with-a-customer), [Performance obligation](https://lopifi.com/md/glossary/performance-obligation), [Transaction price](https://lopifi.com/md/glossary/transaction-price), [Variable consideration](https://lopifi.com/md/glossary/variable-consideration), [Standalone selling price](https://lopifi.com/md/glossary/standalone-selling-price), [Over-time recognition](https://lopifi.com/md/glossary/over-time-recognition), [Point-in-time recognition](https://lopifi.com/md/glossary/point-in-time-recognition), [Deferred revenue](https://lopifi.com/md/glossary/deferred-revenue), [Contract asset](https://lopifi.com/md/glossary/contract-asset), [Remaining performance obligations](https://lopifi.com/md/glossary/remaining-performance-obligations), [Principal versus agent](https://lopifi.com/md/glossary/principal-versus-agent)
- **Previous:** [Locking the period, Accounting · Lesson 13](https://lopifi.com/md/learn/closing-the-month/locking-the-period)
- **Next:** [Deferred revenue, rolled forward](https://lopifi.com/md/learn/revenue-recognition-and-deferred-revenue/deferred-revenue-roll-forward)
- **The course:** https://lopifi.com/md/learn