Revenue Recognition Will Never Be the Same
It has taken over five years of debate to develop, but on May 28th the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers: Topic 606, creating a new codification topic and ushering in a new era of revenue recognition. This new standard is a major achievement of the International Accounting Standards Board (“IASB”) and FASB joint project to converge U.S. GAAP and International Financial Reporting Standards (“IFRS”). With this release, the FASB has now replaced hundreds of industry specific guidance pages with a single, comprehensive standard applicable to virtually all industries that will forever change how we account for revenue recognition. This new standard will also supersede certain cost and gain/loss on transfer of nonfinancial asset guidance.
What do you need know?
First, don’t panic. The standard isn’t effective for private entities until reporting periods beginning after December 15, 2017. For most private entities, it won’t be effective until 2018.
Don’t let the long implementation delay give you a false sense of security. Most entities report comparative financial statements and the new standard requires retrospective application. That means private companies who present comparative financial statements will need to consider this in three years at the very latest. However, if your company has long-term contracts spanning several years, you will need to know all about this standard earlier. We encourage companies to begin development of any new contract templates, and accounting policies and practices before it could impact financial reporting.
The second most important thing you need to know is a basic understanding of the standard. Below is a brief summary.
The conceptual bedrock of this new standard is that an entity shall recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration, in which the entity expects to be entitled in exchange for those goods or services.
Revenue recognition will now be determined by applying a five-step process:
Step 1: Identify the Contract(s) with a Customer
A contract creates legally enforceable rights and obligations, and
meets all of the following criteria:
- Approval and commitment of the parties.
- Identification of the rights of the parties.
- Identification of the payment terms.
- The contract has commercial substance.
- It is probable that the entity will collect the consideration, to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
As part of identifying contracts with customers, an entity might combine separately stated contracts and will need to consider contract modifications.
Step 2: Identify the Performance Obligations in the Contract
A performance obligation is a promise to transfer a good or service. If there is more than one good or service to be transferred, then the entity should account for each as a separate performance obligation only if the good or service is one of the following:
- A series of distinct goods or services that are substantially the same and have the same pattern of transfer.
A good or service is distinct if both of the following criteria are met:
- Customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.
- The promise to transfer the good or service is separately identifiable from other promises in the contract.
A good or service that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct.
Step 3: Determine the Transaction Price
Excluding amounts collected on behalf of third parties, to determine the transaction price, an entity should consider:
- Variable consideration – If all or some of the contract consideration is variable, an entity should estimate the total contract consideration using either the probability-weighted amount or the most likely amount methods. The most likely amount method would likely be used in situations like binary outcomes when a probability-weighted amount would yield an amount that could never actually occur.
- Constraining estimates of variable consideration – An entity should include in the transaction price some or all of an estimate of variable consideration, only to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
- Financing component – For contracts with payment terms greater than one year, an entity should adjust the consideration received for the effects of the time value of money if significant.
- Noncash consideration – An entity should measure the noncash consideration at fair value. If fair value cannot be reasonably estimated, then the value should be measured indirectly by reference to the standalone selling price of the goods or service exchanged.
- Consideration payable to the customer – If an entity pays consideration to a customer (e.g. credit, a coupon, or a voucher), the entity should account for the payment as a reduction of the transaction price or as a payment for a distinct good or service, or both.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
For contracts with more than one performance obligation, the total transaction price determined in Step 3 should be allocated to the various performance obligations in proportion to each performance obligation’s relative standalone selling price. Standalone selling price can be thought of as vendor-specific objective evidence (VSOE) currently used under ASC 985-605 Software Revenue Recognition and is the first level in the relative selling price hierarchy under 605-25-30-2 Multiple-Element Arrangements. If a standalone selling price is not observable, then an entity must estimate it. Acceptable methods for estimating the standalone selling price of a good or service include, but are not limited to, the following:
- Adjusted market assessment approach – For example, a competitor’s price adjusted for the entity’s cost and margins. This is similar to “third-party evidence” of selling price which is the second level in the relative selling price hierarchy currently used under Multiple-Element Arrangements.
- Expected cost plus a margin approach – This is somewhat self-evident but would be an entity’s expected costs plus an entity’s expected margin. This is similar to a “vendor’s best estimate” of selling price, which is currently the third level in the relative selling price hierarchy currently used under Multiple-Element Arrangements.
- Residual approach – For example, total contract consideration less sum of observable standalone selling prices. Nonobservable selling prices may be used to determine the residual amount, so long as evidence of standalone selling prices doesn’t exist. The residual approach is currently not used under Multiple-Element Arrangements, but is a method under Software Revenue Recognition. However, under Software Revenue Recognition, VSOE must exist for all delivered elements which is not the case under this new standard.
A combination of methods maybe used.
Discounts or variable consideration that relates entirely to one performance obligation should be considered and possibly allocated to just that performance obligation, or to just some of the performance obligations rather than to all performance obligations in the contract.
Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation
A good or service is satisfied when (or as) the customer obtains control of that good or service.
Either goods or services are satisfied over time, and thus revenue recognized ratably over time or goods and services are satisfied, and revenue recognized at a point and time.
An entity transfers control of a good or service over time if one of the following criteria 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 (for example, 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.
The amount of revenue recognized for goods and services satisfied over time should be determined using a consistent method of measuring the progress toward completion. Acceptable methods of measuring progress include output methods and sometimes input methods (e.g. costs).
To determine the point in time at which a customer obtains control of an asset, the entity would consider indicators of the transfer of control, which include, but are not limited to, the following:
- The entity has a present right to payment for the asset.
- The customer has legal title to the asset.
- The entity has transferred physical possession of the asset.
- The customer has the significant risks and rewards of ownership of the asset.
- The customer has accepted the asset.
Virtually every industry will be impacted by this new standard; however, some industries will experience greater changes than others. Cherry Bekaert will be releasing a series of blog posts over the following weeks providing more information on the new standard.
Topics: Accounting Standards Update "ASU", Financial Accounting Standards Board "FASB", International Accounting Standards Board "IASB", International Financial Reporting Standards "IFRS", Revenue Recognition