Revenue recognition, as the name implies, is all about how to recognize and record revenue. It’s the accounting foundational principle underlying how companies record income. Revenue Recognition is an authoritative accounting principle that businesses must follow when determining the timing or magnitude of transactions that are recorded relative to revenue.

The International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) in the US require businesses to follow the revenue recognition principles when reporting incomes. These principles allow business to have clarity on when, where and how to record revenue.

The principle of revenue recognition stipulates that revenue should be recognized when it has been earned, not necessarily when it is received. ASC 606 covers the topic of revenue recognition and provides guidelines on when and how to record the sale of goods and services. The four core principles set forth by the ASC 606 are:

1. Identify the Contract. The first step in the process is to identify the contract with the customer. The contract should contain all the essential contractual provisions that specify the rights of both the customer and the seller. It should include details such as the payment terms, delivery of goods/services and warranties.

2. Identify the Performance Obligations. The second step is to identify the performance obligations of the contract. This means that the company should figure out what services or goods are expected from them as part of their agreement with the customer.

3. Determine the Transaction Price. The third step is to calculate the transaction price which is the sum of the contractual cash consideration and any other estimated amounts that the customer is supposed to provide.

4. Allocate the Transaction Price. Lastly, the transaction price must be allocated to the performance obligations in proportion to their stand-alone sales prices. This portion of the process helps businesses understand the value of each part of their contract and ensure that they record the correct amount of income.

Revenue recognition is essential for understanding a company’s financial performance. By following the above principles and understanding the requirements of ASC 606, companies can properly record and recognize their revenues according to GAAP. Such practices increase the transparency of a company’s financials, which can make a significant difference in the decisions of investors and other stakeholders.