What it means
Modern revenue accounting rules ask a simple question: has the customer obtained control of what was promised? Control means the customer can decide how to use the item and can take most of the benefits from it.
Once that happens, the seller has done its job and can recognise the revenue. This replaces older thinking that focused on the transfer of risks and rewards, or on when the invoice was sent.
The control test is more flexible, and it applies to both goods and services. For some contracts control moves at one point in time, and for others it moves gradually as the work is performed.
Indicators that control has moved include that the seller now has a right to payment, the customer holds legal title, the customer has physical possession, and the customer has accepted the item. For a long construction or software project, control may pass continuously because the customer controls the asset as it is built.
The timing matters because it decides which accounting period gets the revenue. Delivering goods on 30 December and obtaining control before the year end puts the sale in this year, while control passing on 2 January puts it in next year.
Shipping terms, acceptance tests and customer rights to return goods all affect the answer. In a second sense, the phrase describes a change of control in a company, such as when a buyer acquires more than half of the voting power.
Contracts, loans and licences often contain clauses that are triggered by such a change, allowing lenders to demand repayment or customers to end an agreement. Finance teams must read these clauses before a deal.
Because the details depend on the contract and the accounting framework, the judgement should be documented. Auditors often examine the point of transfer for large sales close to the period end.
In practice
Real-world examples
Example 1
An equipment supplier ships a machine on 29 December under terms where the customer takes ownership on delivery. Delivery occurs on 3 January, so the supplier records the revenue in January and not in December.
Example 2
A software company sells a licence that the customer can use immediately after receiving the access key. Control passes on that day, so the company recognises the revenue at once instead of spreading it over the contract.
Example 3
A bank has a loan agreement containing a change of control clause. When a buyer acquires a majority of the borrower's shares, the clause allows the bank to ask for repayment, so the finance director must plan refinancing before the deal closes. She opens early talks with other lenders, so the company is not forced to accept poor terms.
Think of it
Handing over the keys to a newly sold car. Until the buyer takes the keys and drives away, the dealership still technically owns the vehicle and its associated risks.
Formula
Calculation
Revenue recognised = Total transaction price x Share of the contract where control has transferred
A manufacturer agrees to sell 4 machines at $30,000 each, so the total transaction price is 4 x 30,000 = $120,000. Under the contract, control of each machine passes when the customer accepts it on its premises. Three machines are accepted before the year end, and the fourth in the following January. Revenue recognised this year = 3 x 30,000 = $90,000, which is 90,000 / 120,000 = 75% of the contract. The remaining $30,000 is recognised in the next year.Case study
Seen in the real world
Valehaven Industrial is an illustrative, fictional machinery maker that wanted to meet its annual sales target. The sales director arranged for a $2,400,000 machine to be shipped before the year end, even though the customer had not agreed to accept it until a test in the next quarter.
The finance controller read the contract and saw that the customer retained the right to reject the machine if it failed the test. Control had therefore not passed, and revenue could not be recognised yet.
The sale was booked in the next period, once the test was passed. In this illustrative story, the company avoided a restatement and added a revenue checklist for large year-end deliveries. The sales director agreed that bonuses on large deals would only be paid after the finance team confirmed the point of transfer in writing.
Watch out
Common mistakes
- Recognising revenue when goods are shipped, even though the customer has not yet obtained control under the contract.
- Using the invoice date as the date of transfer, when control can move earlier or later.
- Missing change of control clauses in loans and contracts before a sale or investment.
Questions
People also ask
How do you know when control has passed?
You look at indicators such as legal title, physical possession, acceptance by the customer, the right to payment and who bears the risks and rewards.
Can control transfer over time?
Yes, for services or long projects the customer may receive and use the benefits as the work happens, so revenue is recognised gradually.
Why do auditors focus on this?
Moving a sale into the wrong period can overstate or understate profit, so period-end sales receive extra scrutiny.