The New Revenue Recognition World
By: Michael Brown, Senior Manager
The effective date for the new revenue recognition standard is fast approaching and will be here before we know it. By now, you have probably heard speculation about the impact of the standard to your company. Speculation has been from no impact at all to the world is going to be entirely different post implementation. As always, the reality is somewhere in the middle.
Generally speaking, for the government contracting industry, the end result of when and how much revenue is recognized will be similar as in the past or at least should not significantly change the end results; but the process to get their will be entirely different. There will be some situations and circumstances when the new standard may require a change in the amount and timing of recognition but these are not expected to impact standard government contracts. One of the best examples I have heard to explain the new standard’s impact is imagine if you’re going to take your annual vacation in a different part of the country. You typically go to the same vacation spot each year using the same method of transportation, airplane. This year and going forward instead of flying, you take the train and bus to get to your location. In the end, you will be in the same vacation spot, but how you got there is entirely different.
The Origin of the New Standard
So why did the Financial Accounting Standards Board decide to make this change? Similar to some of the other more recent changes, the revenue recognition standard was part of the joint project to converge U.S. GAAP and International Financial Reporting Standards (IFRS) in an attempt to foster consistency not just between industries, but all financial statements globally. The new standard will supersede all industry specific guidance that had previously been used to dictate the appropriate accounting treatment. The new standard covers all public, private and nonprofit organizations with very few exceptions.
Public entities and nonprofit entities with public debt are required to adopt the new standard for reporting periods beginning on or after December 15, 2017. Private and other nonprofit entities lucked out, and will get an extra year prior to implementation as their effective date for reporting periods beginning on or after December 15, 2018. This equates to beginning January 1, 2019 for private entities with a December 31 calendar year-end.
Public: Years beginning after 12/15/17 ie. (Calendar Year-end December 31, 2018)
Non-Public: Years beginning after 12/15/18 ie. (Calendar Year-end December 31, 2019)
The core principle of the new standard is that an entity should recognize revenue to depict the transfer of goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To replace the previously used industry guidance, the new standard establishes a five-step process to recognize revenue.
- Identify Contract(s) with Customer
- Identify Performance Obligation(s) (“P.O.”) in the Contract
- Determine Contract Price
- Allocate Transaction Price to Performance Obligation(s)
- Recognize Revenue When Entity Satisfies Performance Obligation(s)
Ultimately, revenue is recognized when a company satisfies a performance obligation by transferring a promised good or service to a customer, which is deceptively simple and even appears logical.
To cover all the specific nuances related to each step would require a lot more space than the newsletter allows and multiple trips to the coffee machine for you. Instead, we are just going to highlight a few aspects of the process while going into further detail in future articles, webinars, blogs and through one on one interaction.
Step 1: Identify Contract(s) with Customer
This is the logical starting point because without a contract, all the remaining steps will not apply. It is important to note that the contract does not necessarily need to be in writing. The requirements of a contract include:
- Approval and commitment of the parties
- Contract to have commercial substance
- Identification of the rights
- Identification of the payment terms
- Probability that the entity will collect the consideration to which it is entitled
Step 2: Identify Performance Obligation(s) in the Contract
A P.O. is a promise to transfer a good or service. If there are multiple goods or services to be transferred, then the entity should account for each as a separate P.O. only if the good or service is distinct, or a series of distinct goods or services that are substantially the same and have the same pattern of transfer.
Step 3 and 4: Determine the Transaction Price and Allocate the Transaction Price to the Performance Obligations
For government contractors this exercise should feel somewhat familiar with how your indirect costs get allocated. There are two ways to estimate the variable consideration:
- The Expected Value – sum of probability weighted amounts in a range of possible amounts.
- The Most Likely Amount – single most likely amount in a range of possible amounts. Typically used when there are only two possible outcomes.
For contracts with more than one P.O., the total transaction price determined should be allocated to the various P.O. in proportion to each P.O.’s standalone selling price. If the standalone selling price is not observable, then it should be estimated.
Step 5: Recognize Revenue when Entity Satisfies Performance Obligation
Finally, we have come to the last step, recognizing the revenue. Recognition could occur in two ways, overtime with recognition being continuous or all at once at a single point in time.
Revenue should be recognized continuously if one of the following is met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- The entity’s performance creates or enhances an asset (e.g., work in process) that the customer controls as the asset is created or enhanced.
- The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
If none of the above are met, than revenue should be recognized at a single point in time. If recognition does occur overtime, the company needs to determine an appropriate method of measurement that best depicts the transfer of goods or services. Some good news, there is a practical expedient that allows the company to recognize revenue if the right to invoice is highly correlated to the value of goods and services delivered in the period that is covered by the invoice. This sounds like typical time and material contracts for government contracts, which would typically retain their current revenue recognition amount and timing.
So now what?
There is still plenty of time to prepare and be ready for implementation of the new revenue recognition standard. Understanding the new terminology and process will allow you to better plan and project any impact it may have to your financial reporting to remain compliant. Any of our service professionals would be happy to assist in simplifying the implementation and providing the necessary training to you and your company. Be on the lookout for more articles, blogs and webinars in the near future that delve deeper into the new standard and proper implementation.