Revenue recognition

In depth

Step 1: the contract

A contract is an agreement that creates enforceable rights and obligations; it can be written, spoken or implied by a business’s customary practice. IFRS 15 (paragraph 9) lists five conditions before the model applies, and ASC 606 has a parallel list:

• the parties have approved the contract and are committed to performing;
• each party’s rights to the goods or services can be identified;
• the payment terms can be identified;
• the contract has commercial substance (it is expected to change the business’s future cash flows);
• it is probable that the business will collect the amount it will be entitled to.

Lantern’s contracts are simple: a catering booking confirmed by email at an agreed price, a workshop registration, an order placed at the shop’s checkout. A customer who later fails to pay, as Quayline Events did, doesn’t mean there was no contract. The loss is a bad debt, which the next module covers in Receivables and payables.

Step 2: the performance obligations

A performance obligation is a promise to transfer a distinct good or service. IFRS 15 (paragraph 27) treats a promise as distinct when two conditions hold: the customer can benefit from it on its own or with resources readily available to it, and the promise is separately identifiable from the other promises in the contract. A catered lunch includes food, coffee and the staff who serve them, but the client is buying one integrated service, so it is one obligation. A sound system sold with installation by the seller’s technician and a support plan is usually three obligations, because a customer could buy each separately and none significantly changes the others.

Step 3: the transaction price

The transaction price is the amount the business expects to be entitled to in exchange for the promised goods or services. It excludes amounts collected on behalf of third parties, such as some sales taxes (IFRS 15 paragraph 47). When the amount can change, because of discounts, rebates, refunds, credits, price concessions, incentives, bonuses or penalties, the business has variable consideration (ASC 606-10-32-6; IFRS 15 paragraph 51). It estimates the amount, but includes it only to the extent that it is probable that a significant reversal of the cumulative revenue recognised won’t occur later (ASC 606-10-32-11). Lantern’s prices are fixed: an agreed price for each event, $125 a workshop seat and a list price for each bag (its refunds for damaged bags, discussed below, are the exception).

Step 4: allocating the price

When a contract holds more than one performance obligation, the transaction price is divided in proportion to their stand-alone selling prices: what the business would charge for each promise sold separately (IFRS 15 paragraphs 74 and 77). A list price is evidence of a stand-alone selling price but isn’t automatically one. When no observable price exists, the business estimates it, for example by an adjusted market assessment or expected cost plus a margin; a residual approach is allowed only in limited circumstances (paragraph 79). A discount for buying the bundle is normally shared among all the obligations in proportion.

The challenging example below allocates a $7,200 bundle across equipment, installation and a two-year support plan whose stand-alone prices add up to $8,000. Each obligation receives 90% of its stand-alone price, so each bears its share of the $800 discount.

Step 5: satisfying the obligation

An obligation is satisfied when the customer obtains control of the good or service: the ability to direct its use and obtain substantially all of its remaining benefits (IFRS 15 paragraph 33). Revenue is recognised over time if any one of three criteria is met (ASC 606-10-25-27; IFRS 15 paragraph 35):

1. the customer receives and consumes the benefits as the business performs (cleaning, a gym membership, a monitoring service);
2. the business’s work creates or enhances an asset the customer controls as it is created (an extension built on the customer’s land);
3. the work creates an asset with no alternative use to the business, and the business has an enforceable right to payment for the work done to date (a machine built to one customer’s design).

Otherwise the obligation is satisfied at a point in time, and the business looks for indicators that control has passed: a present right to payment, the customer’s legal title, physical possession, the significant risks and rewards of ownership, and the customer’s acceptance (ASC 606-10-25-30; IFRS 15 paragraph 38). No single indicator decides; they are weighed together.

F01 described a catered event as delivered at a point in time, a fair shorthand: strictly, it meets the first over-time criterion, because the client consumes the service as Lantern performs it. The performance lasts a few hours on one day, so either way all its revenue falls on the event date, and the same is true of a workshop.

A bag of beans is a good. Lantern refunds bags damaged in transit, so it keeps the risk of loss until the parcel arrives, and control strictly passes on delivery. Its accountant nevertheless recognises shop sales when orders ship: parcels arrive within days, so only orders in transit on 31 December are affected, and they were judged below materiality. With material sales in transit at a year end, revenue would wait for delivery.

Contract liabilities and receivables

A contract liability is a business’s obligation to transfer goods or services to a customer from whom it has received payment, or from whom payment is already due (IFRS 15 paragraph 106; ASC 606 uses the same term). A receivable is a right to payment that is unconditional: only the passage of time stands between the business and the cash (paragraph 108). If the business has performed but its right to payment still depends on something other than time, such as finishing another part of the contract, it holds a contract asset rather than a receivable (IFRS 15 paragraph 107; ASC 606-10-45-3). Lantern’s catering invoices of $59,920 created receivables when the events took place; by 31 December it had collected $51,720 and written off $820, leaving $7,380.

Four of Lantern’s receipts created contract liabilities. The table follows each from receipt to the year end; the journal shows how the year’s summary entries record them.

In early 2027 the $6,100 becomes revenue as Lantern caters the two events, runs the workshop and ships the subscription bags: each delivery debits Unearned Revenue and credits a revenue account. Had Lantern recorded the receipts as revenue in 2026, its 2026 revenue would be overstated by $6,100 and its balance sheet would hide obligations it still had to perform.

Refunds, returns and allowances

When a customer returns goods or is given a price reduction, the business doesn’t erase the original sale. It debits a contra-revenue account, Sales Returns and Allowances, which has a normal debit balance and is deducted from gross revenue on the income statement. Keeping the reduction in its own account shows managers how much selling effort is undone by returns. Lantern refunded $1,025 to customers whose bags were damaged in transit. The damaged beans weren’t resold, so nothing went back into inventory:

When returned goods can be resold, a second entry puts them back into inventory at cost and reduces cost of goods sold, as the next lesson shows. A business that sells with a right of return and expects returns at the year end estimates them instead of waiting: it recognises revenue only for the goods it expects customers to keep, a refund liability for the amount it expects to pay back, and an asset, with a matching reduction of cost of sales, for its right to recover the goods (ASC 606-10-55-23; IFRS 15 paragraph B21). Lantern’s practice of refunding damaged bags is variable consideration in principle, but refunds were under 1% of shop sales and are paid within days, so those still to come at 31 December for late-December shipments were immaterial: its accountant records refunds when paid and recognises no refund liability. A business whose expected refunds at the year end are material must estimate them.

A sales discount rewards prompt payment. Terms of “2/10, n/30” offer 2% off if the customer pays within 10 days, with the full amount due in 30. Introductory texts, OpenStax among them, record the discount in a contra-revenue account, Sales Discounts, when the customer takes it. Under ASC 606 and IFRS 15 a prompt-payment discount is variable consideration, so a seller that expects most customers to take it estimates the discount when it recognises the sale. Lantern’s shop customers pay by card at checkout, so its Sales Discounts account has no balance in 2026; it would be used if Lantern offered credit terms to wholesale customers.

Gross or net: principal or agent

When another party is involved in supplying the customer, the business must decide whether it promised to provide the good or service itself, as a principal, or to arrange for the other party to provide it, as an agent. A principal recognises revenue at the gross amount the customer pays; an agent recognises only its fee or commission (IFRS 15 paragraphs B35B and B36). The test is whether the business controls the good or service before it reaches the customer. Three indicators help (paragraph B37): the business is primarily responsible for fulfilling the promise, it bears inventory risk, and it has discretion in setting the price.

Lantern buys roasted bags from Kilnworth Roasting, holds them in stock, sets their prices and answers customers’ complaints, so it is the principal and reports the full $111,025 as revenue. The card processor and the shop platform are Lantern’s suppliers, not partners in the sale: their $4,010 of fees is an operating expense, not a deduction from revenue. The answer matters for comparisons. A marketplace selling $1 million of other firms’ goods for a 10% commission reports $100,000 of revenue; a retailer selling the same goods as principal reports $1 million and the cost of the goods as well.

Reconciling the shop’s order values with the books

B02 cleaned the shop’s order export for March to June and found order values of $9,096.15; B01 estimated July to December as orders multiplied by the average order value, $101,928.40. Analytics measures orders placed; the books measure obligations satisfied, refunds and cash received in advance. The reconciliation explains every difference:

Three points follow. The analytics figure and the revenue figure agree only because every order in the export was shipped by 31 December; an order placed on 31 December and shipped on 2 January would be 2027 revenue. Refunds are a reduction of revenue, so the shop’s net sales are $110,000, the figure the next lesson uses for its gross margin. And $2,960 of the cash the shop collected isn’t revenue at all yet.