Revenue Recognition Implementation: Getting Into the Details
By: Craig Hunter, Partner
In our last newsletter, we discussed the highlights of the new revenue recognition standard and what everyone should begin to expect. In this article and future articles, we want to go into more detail about the specific requirements of the standard.
As mentioned in the previous edition, the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers: Topic 606. The new standard creates a whole new codification topic (ASC 606), and introduces in a new era of revenue recognition by replacing hundreds of pages of industry specific guidance with a single comprehensive standard applicable to most industries and certainly to the government contracting world, that will significantly change our revenue recognition process.
To depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in the exchange for those goods or services.
The new standard is broken down into five steps.
The Five Steps
- 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)
Step 1: Identify Contract with Customer
A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations.
Under the new standard, a contract under exists only when ALL of the following five elements have been met:
- Approval and commitment of the parties. Approval can be in writing, orally or in accordance with customary business practices. For example, if a company provides customer support for a period of one year, which automatically renews every year unless the customer cancels within 30 days of the automatic renewal, then a new contract would be created automatically once the cancellation window has lapsed.
- Identification of the rights of the parties.
- Identification of the payment terms. Notice this does not require the payment terms to be fixed or determinable as required under previous generally accepted accounting principles (GAAP).
- The contract has commercial substance.
- Collection is probable. Probable is defined as “likely to occur,” to which it is entitled for the goods and/or services delivered. This is very important because if collection is not probable then no contract exists and none of the remaining steps should be considered. For more government contractors, collection should be probable unless unusual circumstances are encountered. Another important aspect is that the standard specifies that “an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due.” This leaves open the possibility that revenue could be recognized even if a customer currently does not have the ability to pay, but is likely to have the ability to pay when contractual amounts become due.
GovCon Example: If a Company has a subcontract with another entity or Joint Venture that is just beginning operations and would not have the ability to make payment at the time of contract execution, it is reasonable to believe that the proceeds from their contract with the Government would subsequently provide the assets and resources to pay the Company (subcontractor) and thus collection would be probable for the subcontractor.
Note on collection: The amount of consideration which the entity believes is probable (i.e., “likely to occur”) of collection does not have to be the contractually stated amount. Rather, the contractually stated amount less expected price concessions. The common business practices and legal environment for meeting the above elements and thereby establishing a contract will vary across legal jurisdictions, industries, and entities. Importantly, it may also vary within an entity based on a class of customer, or the nature of the promised goods or services.
A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed (i.e., no goods/services yet transferred and no consideration has been or is entitled to be received) contract without compensating the other party.
The need to “identify the contract with customer determination” only needs to be completed at contract inception unless there are indications of a significant change in one of the five elements. For example, if a customer’s ability to pay the consideration deteriorated significantly subsequent to the contract formation, management will have to assess whether the deterioration relates to performance obligations previously satisfied, performance obligations to be performed in the future, or both. If a contract doesn’t meet the above elements at inception, then it should be reassessed each reporting period to determine whether the elements have been met.
An entity shall combine two or more contracts entered into at or near the same time with the same customer (or related parties to the customer), and account for the contracts as a single contract, if one or more of the following criteria are met:
- The contracts are negotiated as a package with a single commercial objective.
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
- Some of the goods or services promised in the contracts are a single performance obligation.
Step 2: Identify Performance Obligation(s) in the Contract
A performance obligation is defined as a promise to transfer a good or service. A performance obligation can be explicitly stated in the contract or it can be implied. Activities undertaken to fulfill a contract are not considered a performance obligation unless those activities transfer a good or service to a customer. For example, overhead and general administrative tasks might be performed but that does not constitute a performance obligation because no good or service is transferred to the customer.
A performance obligation shall be allocated a portion of the transaction price if either of the following is true:
- The good or service (or a bundle of goods or services) is distinct; or
- The good or service is part of a series of distinct goods or services that are substantially the same, and have the same pattern of transfer to the customer.
A good or service is distinct if both of the following are met. First, the customer can benefit from the good or service either on its own or together with other resources readily available to the customer. Typically, an example of if a customer can benefit from the good or service on its own would be if the entity regularly sells the good or service separately. Second, the promise to transfer the good or service is separately identifiable from other promises in the contract.
Some factors to consider in determining whether a good or service is distinct are as follows:
- The entity does not provide integration services for that good or service with other goods or services promised in the contract;
- The good or service does not significantly alter other goods or services promised; and
- The customer could decide to not purchase the good or service, and it would not significantly affect the other goods or services promised in the contract.
If a good or service is not distinct, then it should be combined with other goods and services until a bundle of goods or services are distinct.
As you can see, this is a lot of information to consider, and this is just the first two of five steps of the new revenue recognition standard. In future newsletters, we will complete the discussion of the remaining steps that should be performed in the revenue recognition standard.
Public: Years beginning after December 15, 2017 (i.e., calendar year-end December 31, 2018).
Non Public: Years beginning after December 15, 2018 (i.e., calendar year-end December 31, 2019).