Final answer:
The five steps in the revenue recognition process are identifying the contract with a customer, identifying performance obligations, determining the transaction price, allocating the transaction price to the performance obligations, and recognizing revenue when each performance obligation is satisfied.
Step-by-step explanation:
The revenue recognition principle is a cornerstone of accrual accounting and the matching principle. The revenue recognition standard issued by the Financial Accounting Standards Board (FASB) outlines five steps for recognizing revenue effectively and accurately:
- Identify the contract(s) with a customer: A contract is an agreement between two or more parties that creates enforceable rights and obligations. The recognition process begins with identifying the contract regarding the transaction.
- Identify the performance obligation(s) in the contract: Performance obligations are the promises in a contract to transfer goods or services to the customer. Companies must identify each good or service promised to a customer.
- Determine the transaction price: This is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods or services. Potential discounts, rebates, refunds, and other variables must be considered.
- Allocate the transaction price to the performance obligations in the contract: If a contract has multiple performance obligations, the company must allocate the transaction price to each performance obligation based on the stand-alone selling prices.
- Recognize revenue when (or as) the entity satisfies a performance obligation: Revenue is recognized when control of the promised goods or services is transferred to the customer, which may occur over time or at a single point in time.
By applying these steps, businesses ensure that revenue is recorded in the appropriate period, in accordance with the accrual basis of accounting, reflecting the actual earnings process.