Understanding the difference between revenue and income is essential to understanding revenue recognition:
- Revenue is defined as the total amount of money a business receives from its customers. Revenue is the first line on the company’s income statement.
- Income (or net income) refers to the company’s net profit (i.e., the amount that is left after expenses and taxes are subtracted from revenue). Income is the last line — the bottom line — on the company’s income statement.
The Revenue Recognition Principle
The revenue recognition principle is more complicated. It sets a standard that requires revenue to be recorded when it is earned rather than when it is received. Requiring all company financial statements to use the same formula for reporting revenue is intended to provide a certain level of comparability between companies.
Accounting Standards Codification 606 Made Fundamental Changes
In practice, the principle requires that a revenue-generating activity must be completed or effectively completed in the same accounting period that payment is received or is expected to be received. Accounting Standards Codification (ASC) 606, which was enacted in 2014, fundamentally changed how it is applied. ASC 606 became effective for public companies in 2018 and for privately held companies in 2019. Previously, the reporting standard varied according to industry. Now, under ASC 606, the standard is industry neutral, making it more transparent.
ASC 606 applies to all contracts with customers, except for leases, insurance contracts, financial instruments, guarantees and certain nonmonetary exchanges between entities in the same line of business.
Five Steps to Determining When Revenue Is Recognized
Use the following five steps to determine when revenue is recognized:
- Identify the contract
- Identify the contractual performance obligations
- Determine the amount of consideration/price for the transaction
- Allocate the determined amount of consideration or price to the contractual obligations
- Recognize revenue when or as the performing party satisfies performance obligations
This may sound simple, but following ASC 606 may require adjustments to a company’s policies, processes and systems. Segmenting each performance obligation and its associated costs can be quite difficult and time-consuming.
Adopting the Standard: Tax Implications
The rules provide for two alternatives for adoption of the new standard:
- The full retrospective method. This method requires the restatement of the company’s 2018 results of operations to reflect a cumulative effect adjustment as of the beginning of 2018.
- The modified retrospective method. This method doesn’t require restatement. Instead, it presents the cumulative effect adjustment as of the beginning of 2019. It requires, however, additional footnote disclosures that explain any inconsistencies between the company’s 2018 and 2019 financial statements.
Tax implications also must be considered. Adoption of the new standard will affect taxable income, including pretax income, of all entities. In addition, adoption of ASC 606 will require making income tax–related adjustments under ASC 740 on the date of adoption.
All of this means that you must be sure how ASC 606 affects your business before preparing your next financial statement.
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