Understanding Revenue Recognition

Business processes and financial standards outline when you can recognize revenue for the amounts you bill to customers. You cannot recognize revenue for billed amounts or Cost of Goods Sold (COGS) amounts associated with the billing amount until the performance obligation to the customer is satisfied.

Every company and each of their customers must agree to the terms that constitute the completion of a performance obligation. Performance obligations can be satisfied in different ways and at different times. Examples include:

• Retail

  The customer takes possession of the goods and is billed at the time of the sale. The performance obligation is complete and revenue is recognized at billing.

• Services

  Services are completed for a customer and they sign off on the work. The performance obligation is complete at the time the customer signs off on the work and revenue is recognized at billing.

• Distribution

  Goods are shipped to a customer and they are billed at the same time. The performance obligation is not complete until the customer takes possession of the goods and accepts them as complete. Therefore, you cannot recognize revenue at the time of billing.

  The system accounts for the billing amount as a performance liability. Once the customer takes possession and accepts the goods, the revenue is recognized and the performance liability cleared. Any COGS amounts associated with the billing amount is also considered a performance liability and can only be recognized once the performance obligation is complete.

• Construction

  In some industries, such as construction, customers are billed for portions of the contract that are complete, or for time and materials as they occur. Revenue recognition is tied to the terms of the contract for each type of billing line. Some billing lines can be recognized immediately and others may be considered a performance liability until other terms have been met.

• Real Estate Management

  In some real estate management scenarios, customers are billed for rent and other lease-related charges in advance. When this happens, it is likely that you cannot recognize the revenue for the full portion of the invoice until the performance obligation has been met. For example, if you bill a customer for six months of rent in advance, you cannot recognize the full amount of the invoice at the time of billing. Instead, you might recognize one sixth of the revenue after each month that the tenant uses the space for which they are billed.

As illustrated in the previous examples, you cannot recognize revenue or COGS on all transactions at the time of billing. In these cases, the transactions are processed separately using performance liability accounting and revenue and COGS are recognized upon the completion of the obligation.