Most simple financial transactions involve a customer requesting goods or a service and paying for them immediately. This is an easy accounting process when recording the transaction as revenue. But, what happens when there are complex, high-value contracts at play? These types of contracts typically involve delayed payment or payment in installments. This begs the question, “when and how can they be recorded as revenue?”. In this article, we’ll detail the Contracts with Customers accounting standard and how you can incorporate them into your contracts. We’ll also discuss the importance of accounting journal entries to accurately understand the financial health of your business.
Let’s start by clarifying what revenue is. Revenue is a resource gained from providing a service or a product:
What’s not counted as revenue is when the customer gives you the money, but you haven’t provided the product or service yet.
Revenue accounting is therefore recording the revenue when the benefits and risks of ownership have been transferred to the customer, and the payment has been completed.
Identifying a contract is a critical step in revenue recognition as it dictates when and how revenue should be recognized. Companies need to thoroughly evaluate contracts to determine the appropriate timing and method for recognizing revenue to reflect the transfer of goods or services to the customer.
Identifying a contract involves several key elements that must be present to recognize revenue accurately. The identification of a contract typically needs to involve the following:
Recognizing a revenue contract with a customer is more complicated. Contracts are typically drawn up for the provision of large amounts of goods and services. Think construction contracts or the provision of maintenance over a period of time. Because these types of contracts usually involve large sums of money, payment is generally given in installments.
Contract accounting revenue recognition has five steps that must be satisfied to recognize revenue:
ASC 606 is a revenue recognition standard that public and private companies must comply with.
Created by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), the ASC 606 is a way for businesses to recognize their revenue in a more consistent way.
It details how businesses should report the nature, amount, and timing regarding their contracts with clients and customers. It is especially important for businesses that sell recurring services such as licenses and subscriptions.
ASC 606 contracts with customers are more in-depth as they break down the assets into milestones and assign a value to each one.
The biggest change surrounding the ASC 606 is for companies that provide services. This is because it changes the frequency with which they have to allocate revenue.
To improve comparative analysis and reporting and to make the preparation of financial statements easier, the ASC 606 revenue recognition criteria consist of a five-step framework:
ASC 606 service contracts will have each step detailed within it, so both the customer and the seller know exactly what needs to be achieved to receive payment.
Essentially, revenue can be recognized when realized (the critical event) and earned (when the money received matches the price). There can, however, be delays in receiving the money. For example, when a customer pays for something in installments. However, since they agreed to buy (critical event) and the money will eventually match the price, it can still be counted as revenue.
Since recognizing revenue from contracts with customers has several different methods, there is no “one size fits all” way for businesses. It’s important to note that the wrong method can lead to inflated or deflated revenue, profit, and expenses being recorded. It can also affect your tax liability and investment opportunities.
To determine which method is most ideal for you, you need to look at your business model and your ASC 606 performance obligations. Use the method that best reflects the business reality detailed in your financial statements.
This is where the performance obligations come into play. A contract asset can only be recognized when a performance obligation is met, but the payment is still conditional on other performance obligations being satisfied.
Essentially, if you’ve set out specific milestones within the contract, as each one is achieved, the value of it can be recorded as an asset.
Journal entries are crucial if a business wishes to have its business transactions recorded accurately. It is a detailed record of all business transactions conducted, which is used to generate accurate financial reports such as cash flow and balance sheets. Recording debits and credits at the same time and gives a clear overview of ingoing and outgoing resources. This is especially important if your business is ever subject to an audit.
Big Company has agreed to provide product A and service B to Mr. Customer. The contract states that product A must be delivered first, but payment will not be made until service B is provided.
Big Company has stated on the contract that product A and service B are two different performance obligations. A value of $1,500 has been allocated to product A and $3,000 to service B.
The journal entry will therefore look like this:
Big Company satisfies performance obligation 1 – product A being delivered to Mr. Customer.
Contract asset – $1,500
Revenue – $1,500
Big Company satisfies performance obligation 2 – service B being provided to Mr. Customer.
Receivable – $4,500
Contract asset – $1,500
Revenue – $3,000
Another example is where there’s a contract asset that results from a contract involving multiple performance obligations over a number of years:
Big Company provides a service for three years to Mr. Customer. $6,000 worth of software will be initially delivered. Support is provided at the cost of $2,000 per year. The total price of the contract is $12,000. The customer is invoiced annually on January 31 for $4,000 per year. The way the transactions are split means that Mr. Customer pays for a portion of the cost of the software over the three-year period but receives it upfront. The software and the support services are different performance obligations, and the service part of the contract was deemed to be a stand-ready obligation. The resulting allocation of the transaction price to each performance obligation results in 20 percent of the revenue ($2,400) allocated to the software and 80 percent of the revenue ($9,600) allocated to the support services.
The journal entry will look like this:
On January 1, 2023, control of the software is transferred to the customer, and payment of $4,000 is received:
Cash (20% x $4,000) – $800
Receivable – $1,6001,000
Revenue – $2,4001,000
Cash (80% x $4,000) – $3,200
Contract asset (years 2 & 3) -$6,400
Contract liability (years 2 & 3) – $9,600
Cash – $4,000
Receivable – $1,600
Contract asset (years 2 & 3) – $6,400
Contract liability (years 2 & 3) – $9,600
Revenue – $2,400
On January 31, 2023 (and each month thereafter), Big Company would recognize revenue for support services as follows:
Contract Liability (($9,600/36) x 1 mo.) – $267
Revenue – $267
On January 1, 2023, a payment of $4,000 is received:
Cash – $4,000
Receivable – $800
Contract asset – $3,200
Yes, you can use journal entries to track progress billing. This is where the customer has agreed to pay in installments. The progress payments are raised for the recovery of the amount for a defined period (yearly, monthly, etc.)
Since performance milestones are recorded as value assets, it’s essential that they are noted in the journal entry.
When dealing with journal entries, there are a few common pitfalls and errors that you’ll want to steer clear of to keep your financials accurate and compliant. Here’s a breakdown:
By keeping these common pitfalls in mind and double-checking your work, you can help ensure that your revenue recognition journal entries are both accurate and compliant, keeping your financials solid and reliable.
Preparing financial statements takes in-depth knowledge and expertise, and we’re betting that you’re a business owner, not a financial expert. However, many business owners take it upon themselves to record and manage the company’s finances. Without the proper training, it leaves you wide open to errors and the inability to understand how your business is truly performing.
Employing a qualified accountant or bookkeeper is the best way to ensure your financial statements are properly prepared.
The issue is that most small businesses and startups cannot justify the cost of hiring an in-house professional. This is where the advantages of virtual accounting come into play. Hiring a virtual accountant means you’re only paying for services on a “needs” basis. The more you scale your business, the more you can request from your virtual accountant. Essentially, you only pay for what you need.
Virtual Accountants from Finvisor can help you with all aspects of financial planning. They can assist you in developing a compliant ASC 606 contract for your customers and take care of all the journal entries for you. Get in touch today to find out more.
To learn more about what we do, or to request a quote, contact us at hello@finvisor.com or 415-416-6682. We’re here to help you navigate deferred revenue journal entries so you can make the most of your assets!
