Revenue recognition: navigating the five-step model

The Financial Reporting Council’s (FRC’s) 2024 Periodic Review Amendments to UK GAAP are already effective, bringing FRS 102 more closely in line with International Financial Reporting Standards (IFRS) and affecting key areas such as revenue recognition and lease accounting. In particular, the changes to revenue recognition introduce the five-step model, which is now well embedded in IFRS standards.

Preparers and auditors alike should be familiar with the mechanics. This article looks beyond the five-step model to consider some of the practical implementation issues.

A control-based model

The amendments to FRS 102 replace the former risk-and-rewards approach with a control-based five-step model. Revenue is recognised when control of a good or service transfers to the customer. While the framework is clear, the model is more prescriptive and requires judgement at each stage.

Even if the pattern of revenue recognition does not ultimately change, updated disclosures must reflect the assessments made under the new model. For example, even a simple retail transaction requires explicit consideration of refund provisions, discounts or loyalty schemes, which may need to be reflected and disclosed. Transition therefore requires a careful walkthrough of all the model’s steps. 

Identifying contracts

Identifying the contract requires both parties to be committed to their obligations, with clearly identifiable rights, commercial substance and the probability of collection of consideration. In practice, difficulties arise where historic contracts lack clarity or where intercompany or informal arrangements have developed over time. 

Although contracts may be approved through customary business practices, the underlying obligations can be difficult to articulate. Contract modifications further complicate matters and must be assessed to determine whether they represent a separate contract or a modification to the original agreement. This distinction is important as it may affect the timing of any revenue adjustment and may also alter the identification of performance obligations, with previously distinct obligations needing to be combined, or vice versa.

Performance obligations in the contract

Identification of performance obligations is a new and central concept under Section 23 of FRS 102. The key question is whether goods or services are distinct, meaning the customer can benefit from them on their own rather than in combination with others. Additionally, the promise to transfer goods or services to the customer must be separately identifiable from other promises in the contract. 

Non-refundable upfront fees, such as membership, activation or set-up fees, often require careful analysis. For example, an upfront gym membership fee may merely grant access to future services and therefore would not be distinct, resulting in revenue being fully recognised over the contract term rather than upfront. Other contractual features that frequently require closer scrutiny include warranties, which may or may not represent a separate service, and principal versus agent considerations where guidance has been enhanced and reassessment may be required. 

Determining the transaction price

Determining the transaction price can also involve significant judgement. Consideration must be given to the time value of money where there is a significant timing difference between performance and payment. Adjustment for a significant financing component is generally required in deferred payment arrangements, while a practical expedient may be available in some circumstances where customers pay in advance. Consideration is also needed where payment terms fall outside normal business practice or involve non-market rates. Variable consideration presents particular challenges and can only be included in the transaction price where it is highly probable that it will not reverse. This may include rebates, refunds, price concessions, rights of return, penalties or performance bonuses. 

Where consideration is received in advance but may be refundable, entities must assess whether a refund liability should be recognised. For retailers, this may involve judgement around what constitutes a genuine return as opposed to a simple exchange. Non-cash consideration also requires careful assessment, typically at fair value, as does consideration payable back to the customer, such as credits or vouchers.

Allocating transaction price to performance obligations

Allocating the transaction price to performance obligations is based on the relative stand-alone selling price basis, information that may not previously have been required or be readily available. In some cases, benchmarking or estimation exercises may be needed to determine these values. This allocation is fundamental and directly affects how discounts and variable consideration are applied, with the potential for a material impact on the timing and profile of revenue recognition.

While the revised FRS 102 permits discounts or variable consideration to be allocated specifically to particular performance obligations in limited circumstances, the criteria for doing so are restrictive and require clear evidence that the allocation appropriately reflects the consideration relating to those obligations.  

Recognising revenue

The final step – recognising revenue – requires judgement to determine when control has transferred to the customer. This dictates whether revenue is recognised at a point in time or over time. The revised FRS 102 is also more prescriptive than the previous standard in relation to the timing of revenue recognition. In particular, paragraph 23.81 provides clearer criteria for determining when revenue should be recognised over time rather than at a point in time, requiring a more structured assessment of when control transfers to the customer. Careful analysis of shipping terms, bill-and-hold arrangements and acceptance clauses is essential. 

This step is often particularly challenging for licence arrangements, where the nature of the rights granted to intellectual property will determine the timing of revenue recognition. Licences that grant rights to software or media without ongoing obligations for modification, maintenance or support may result in point-in-time recognition, whereas other arrangements may require recognition over time. 

Although the year end may still appear some distance away, it is important to get ahead of these changes. From an audit perspective, revenue recognition under the revised standard is likely to represent a specific risk that requires tailored audit procedures. The level of risk will depend on factors such as the complexity of revenue streams and the readiness and capability of the client finance team to manage transition. Auditors will need to understand how any transition adjustments have been calculated and recorded, including whether changes have been embedded within systems or processed as year-end adjustments. 

For preparers, understanding and modelling the impact of the changes in advance can help manage stakeholder messaging and inform decisions on transitional options, whether they are fully retrospective or modified. 

Documentation should begin with a comprehensive, client-prepared inventory of key contracts. Auditors should ensure that this is consistent with their understanding of the business. Completeness is essential. For each of the model’s steps, key judgements – particularly in less straightforward areas – must be clearly documented. This documentation supports not only the recognition of revenue but also the related disclosures. 

Clear communication is critical to ensure that management understands its responsibilities for making the judgements. Auditors should adhere to the relevant ethical standards to avoid assuming management responsibility, making transition work particularly challenging where safeguards may be difficult to apply or boundaries are blurred.

Consistent and proportionate application

While the five-step model provides a clear framework, its real challenge lies not in understanding the mechanics but in applying them consistently and proportionately to real-world arrangements. In practice, the most difficult areas are rarely the headline transactions, but rather legacy contracts, informal arrangements and embedded features such as variable consideration, upfront fees and warranties. 

These judgements must now be explicitly identified, evidenced and disclosed, even where they do not ultimately change the timing or amount of revenue recognised. Good practice therefore goes well beyond simply working through the steps of the model.

A robust contract inventory, early engagement between preparers and auditors, clearly defined responsibilities and contemporaneous documentation explaining both conclusions reached and alternatives rejected will be key to achieving a smooth transition and meeting regulatory expectation.

Anna Hicks, Partner, Saffery