In my previous post, we defined revenue and determined that revenue is earned as a result of performing our primary business activity. That activity could be anything from selling cars to selling software to providing consulting services or providing healthcare services.
Now that we have an idea of what revenue is, how do we go about recognizing it?
There are many different ways of recognizing revenue and there is specific guidance from the FASB (the chief accounting rule setting body) on certain types of revenue (interest income, investment gains and revenue earned from leases, to name a few). These we will steer away from, in this discussion, as these are excluded from the scope of ASC 606 – Revenue from Contracts with Customers (ASC 606). We will steer into the lane related to revenue earned as a result of entering into contracts with customers.
The 5 Stops Along the Road to Revenue
The first stop on our journey will be to determine whether we have a contract with a customer.
Once we get through that stop, we’ll venture on to our second stop, identifying what we are obligated to do for the customer under the terms of the contract (our performance obligations).
After this stop, we’ll take a slight break before proceeding on to our third stop, at which point we’ll figure out what the sales price is (transaction price).
At the fourth stop we’ll divide the sales price between the different performance obligations that we identified on our second stop (allocate the price).
Once we’ve gotten through this stop, we’ll venture on to our fifth and final destination, which is where we recognize revenue.
By now you are probably scratching your head wondering what this means and why should you care, right? My goal in this post, and future posts, is to de-mystify all of the revenue recognition guidance and help you understand it better and it’s implications for your business. By doing this, you’ll have clear insight into the revenue driven by your business and will be able to grow and prosper.
What Is a Contract?
Let’s look at each part separately first, then bring them back together at the end.
Merriam-Webster defines a contract as “a binding agreement between two or more persons or parties” one that “legally enforceable” or “a business arrangement for the supply of goods or services at a fixed price.”
ASC 606 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations,” further “contracts can be written, oral, or implied by the entity’s customary business practices.”
You have a contract with someone (whether that someone is a person or business entity) regardless if it’s a 200 page document that took months and room full of lawyers to craft and agree to or if it’s something you verbally told someone you’d do and they agreed to pay you for.
Now that we get what a contract is, what is a customer?
What Is a Customer?
That’s easy. Isn’t it? When we turn to Merriam-Webster, we find that a customer is “someone who buys goods or services from a business.” The ASC 606 has a very similar definition of customer, “a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.”
Boiled down, a customer is someone that purchases goods or services that we produce in the ordinary course of our business (the reason we’re in existence), whether that customer is someone that walks into our store off of the street an buys a pair of jeans off the shelf, or a multi-million dollar business that contracts with us to perform specialized consulting services.
It usually is pretty easy to determine if you’ve got a customer/vendor relationship going, but there are times when this is not clear. This is when expert advice may be needed.
Combining Contracts and Customers
Now that we are clear on what a contract is and who our customer is, let’s put them together and see what we get. For the most part, we get a contract with a customer.
Most contracts with customers will be easy to identify and straight forward while others may require some digging and analysis to fully understand.
In quite a few cases, these contracts will be very easy to identify as they will be lengthy documents that will have been negotiated and agreed to between ourselves and our customer, but some customer contracts may not be readily disernable. Say your customer comes into your store and picks a pair of jeans off of the shelf and buys them, you have just entered into, executed and completed a contract for the sale of the jeans to your customer.
On the other hand, your customer may call you to engage your services in implementing your specialized computer software package, you negotiate the sales price and terms of delivering the software and an annual maintenance agreement as well as a team to implement the software for the client, you’ve just entered into a contract with your customer.
That being said, there is one more element that we need to discuss which is a key criteria for having a contract with a customer.
That is, according to ASC 606, the customer must be ready, willing and able to pay the agreed to price. You must be fairly certain that you’ll receive the sales price. If not, you don’t have a contract with your customer.
Thank you for going down the road to revenue with me to this first stop.
Ready for the next step? Read the next post in the Road to Revenue Series: Performance Obligations.
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