The new regulations introduced the concept of “performance obligations” within contracts that you need to identify and use as the triggers for recognizing your revenue.
A performance obligation is a promise to deliver a distinct product (a good or a service) to a customer. A contract may contain multiple performance obligations, depending on the nature of the goods and services it includes, and you can account for those using different revenue recognition methods.
Understanding what your performance obligations are and how they are satisfied is vital to choosing the best method for your company’s revenue recognition.
Common Revenue Recognition Methods
1. Sales-basis method
Under the sales-basis method, you can recognize revenue at the moment the sale is made. For example, a customer walks into a store and purchases an item. You can recognize that revenue immediately.
You can use this method whether the customer pays with cash, on credit or even has a high likelihood of paying. This method is not dependent on payment, it is the delivery of the goods or services that triggers the revenue recognition event.
Most retail businesses use this method because delivery is immediate and clear, even if payment is not received right away.
2. Completed-Contract method
The completed-contract method allows you to recognize revenue when the entire contract is fulfilled; when all performance obligations have been satisfied. Completed-contract is a good method for shorter contract periods to ensure revenue appears on financials in the correct period. It is not a good method if you are offering extended warranty periods or have a long-term return policy.
Sometimes this method becomes the default for situations where a company cannot recognize revenue on the “percentage of completion” method due to a lack of clarity around performance obligations or when the contract is not enforceable.
3. Installment method
The installment method is generally used for high-ticket purchases (think real estate, home appliances, large machinery) when the reliability of customer payments is not guaranteed. Because the company is unsure about receiving payment, the installment method lets them recognize revenue (as a percentage of total revenue) only when payments are received, which could be over months or years, and often is unexpected.
Most methods allow you to estimate revenue and expenses if you have a high degree of probability that your estimates will be correct. The installment method may be your best bet if you lack knowledge about if or when you will receive payments.
4. Cost-recoverability method
The cost-recovery or -recoverability method is another option when you can’t estimate the likelihood of collection. Use the installment method when you know the related costs and the cost-recoverability method when you don’t know (or can’t estimate) the costs of the goods and services related to the contract.
Under this method, which is the most conservative revenue recognition method, you can recognize revenue only after you have recouped all the costs associated with the contract. That could be long after the contract is otherwise completed and performance obligations have all been satisfied.
5. Percentage of completion method
Commonly used with large or long-term contract agreements, the percentage of completion method allows companies to recognize revenue according to milestones or other indicators of progress. This method requires a detailed contract that delineates each milestone or deliverable to make it clear when revenue recognition may take place.
The percentage of completion method allows you to recognize revenue closer to real-time, rather than waiting until the end of a lengthy contract. Financial statements show a more consistent stream of revenue with fewer large spikes and revenue is more predictable.
What’s the Right Method for You?
Each method discussed here, as well as other available methods, has advantages and disadvantages and each has a proper use case. Select the method that fits your business model and best accounts for your distinct performance obligations.
Selecting the wrong method can lead to inflated or deflated revenue, expense and profit numbers. If those numbers are inaccurate, it can affect management decisions, tax liability and investor confidence. Use the method that best reflects business reality in your financial statements.
Remember that revenue recognition guidance doesn’t just cover how you record revenue, but how you account for the costs involved in obtaining a contract (like sales commissions) and fulfilling a contract (like labor, materials, PP&E).
Learn more about how clear and accurate sales compensation reporting can make compliance with ASC 606 a breeze.