It is essential to analyze each transaction to identify the attributes of the transaction that impact revenue.
In order to recognize revenue from a transaction, companies must meet the following criteria.
- An Agreement exists between the company and the customer.
- Price must be fixed and determinable.
- The collection is reasonably assured.
- Proof of delivery of products or services must exist.
Before any other decisions can be made, it is essential that you analyze the transaction to determine how and when each criterion will be met. This means answering questions such as
- Which document represents the full transaction? Is the contract represented by a single order or multiple orders?
- Does this transaction modify an existing contract or is this a new agreement?
- Can each good or service be used individually or are they dependent on other goods or services being fully delivered?
- Is the price of this service fixed or does it vary based on usage?
- When will the good or service be delivered? Is it delivered all at once as a hard good? Or is it delivered over time as a service?
- Does the contract give the customer the ability to cancel at any time?
- Is this revenue recognized over time or immediately?
- What are the important dates for revenue? Will the start of revenue be delayed?
- If recognized over time, how will revenue be distributed across the revenue term?
The answers to these questions will allow you to determine how should revenue be recognized for each good or service. This allows you to identify a Revenue Recognition Policy or Rev Rec Rule to be used to recognize revenue for each good or service.
For more complex scenarios, revenue for a service may be different than the amount which has been invoiced. In these situations, it is necessary to calculate the total revenue that will be recognized for each good or service over the life of the contract. Multi-element Arrangements (MEAs) occur when we group multiple items together for the revenue recognition purposes. This is most common in the case of bundles but could also occur when multiple items on a contract are related.
For example, a sales representative could provide 2 years of service for free as part of a deal. From a billing perspective, the value of the service is zero. For revenue, we need to consider the fair value of the service and account for that as revenue over the 2 years the service is provided.
A variety of approaches exist for calculating the fair market value in MEA scenarios:
- Vendor Specific Objective Evidence (VSOE) - this method is used when a good or service is sold by the vendor as a standalone offering. When using this method, the standalone price is used.
- Third Party Evidence (TPE) - this method is used when a good or service is not sold by the vendor as standalone but similar services are offered as standalone services by other vendors in the market. When using this method, the average price of that other vendors charge for the equivalent service is used.
- Best Estimated Selling Price (BESP) - this method is used when the good or service is not sold as a standalone offering by any vendor.
Once calculated, this value will be stored in Revenue Recognition for each revenue item.
As a result of performing these steps, the transaction will be broken down into individual goods or services. For each good or service, you will know how much revenue will be recognized as well as the rule or policy you will use to distribute that revenue.
It is essential to understand the core elements of Revenue Recognition.