Revenue recognition, explained simply
For diligence the practical question is whether revenue sits in the right period. Recording a sale before delivery, or recognizing an annual prepayment in full on day one, overstates the current period and understates the next.
Aggressive recognition immediately before a sale is a well-known risk, so revenue testing is central to a quality of earnings analysis.
Where the revenue belongs
IllustrativeAlder Creek, an order of $0.4 million around the 2025 year end
Recording revenue on invoice in December moves about $0.13 million of profit, at a 33% gross margin, from 2026 into 2025.
The five steps of ASC 606
- Identify the contract with the customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the price to the performance obligations
- Recognize revenue when, or as, each obligation is satisfied
Common issues found in diligence
| Issue | Example |
|---|---|
| Cash-basis accounting | Revenue recorded when paid rather than when earned |
| Early recognition | Invoicing before goods are shipped |
| Upfront payments | Annual fees recognized in full on day one |
| Rebates and returns | Discounts granted later but not accrued |
| Bundled contracts | Product and service sold together, recognized as one |
Worked example
In late December 2025, Alder Creek invoiced and recorded a $0.4 million order. The goods shipped on 5 January 2026, so the revenue belongs to 2026. At a 33% gross margin, about $0.13 million of profit moves from 2025 into 2026.
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
Why it matters in a deal
Revenue timing affects EBITDA, working capital and trends. A spike at period end, or a policy that favors early recognition, is a recognized risk in the months before a sale.
Red flags
- A spike in sales in the final days of a period
- Revenue rising while deferred revenue falls
- No written revenue recognition policy