Revenue Recognition Changes… Are you Ready?June 17, 2014
Why the Change?
As the business climate continues to evolve and become more global, it has become increasingly important to ensure comparability of financial information reported by companies around the world. Accounting Standards Update 2014-09, Revenue from Contracts with Customers (the Update), was a result of a joint project between the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) with the goals of clarifying the principles regarding revenue recognition and developing a common revenue standard for both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
As a result of over ten years of working together on this joint effort, the FASB issued this Update (over 700 pages), which creates a new Topic 606, Revenue from Contracts with Customers, and the IASB issued IFRS 15, Revenue from Contracts with Customers. The issuance of these documents creates common revenue recognition guidance for GAAP and IFRS by removing inconsistencies, providing a more robust framework for addressing revenue issues, improving comparability, providing more useful information through improved disclosures and simplifying the financial reporting process by reducing the number of requirements to which an entity must refer.
What is Changing Under GAAP?
The Update supersedes the requirements of Topic 605, Revenue Recognition and most industry specific guidance that has applied in the past. In addition, requirements for the recognition of a gain or loss on the transfer of non-financial assets are amended to be consistent with the guidance within the Update.
In the past, GAAP has been focused on the earning process. This means that the seller would recognize revenue upon the completion of, or substantial completion of, what they agreed to do under the agreement with the customer (formal or informal). Our current basic revenue recognition criteria state that revenue is recognized when the following criteria are met:
- There is persuasive evidence of an arrangement;
- The price is fixed or determinable;
- Delivery has occurred or the service has been performed; and
- Collectability is reasonably assured.
In contrast, the Update amends GAAP to state that “an entity should recognize revenue 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 exchange for those goods or services.” When determining whether the entity should recognize revenue, the entity would apply the five-step process outlined in the Update as follows:
- Identify the contract(s) with the customer;
- Identify the performance obligations in the contract;
- Determine the contract price;
- Allocate the contract price to the performance obligations; and
- Recognize the applicable allocation of revenue when the entity satisfies each performance obligation.
Step 1: Identify the Contract
A contract with a customer can be verbal or written. It is a commitment between two parties which has commercial substance. While this is not a substantial change from current practice, the Update does specifically define a contract and also offers guidance on accounting for contract modifications, which, in some industries, are common practice.
Step 2: Identify the Performance Obligations
The term “performance obligation” is one of the more significant changes to the Update. A performance obligation is defined as “a promise in a contract with a customer to transfer a good or service to the customer.” Within a contract, there can be one performance obligation or many performance obligations. A promised good or service is accounted for as a separate performance obligation when the promised good or service is capable of being considered distinct, meaning the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer and it is distinct within the context of the contract, meaning that the promise to transfer the good or service is separately identifiable from other promises in the contract. Goods or services that are not distinct would be bundled with other goods or services until they become distinct and treated as one performance obligation.
Step 3: Determine the Transaction Price
The transaction price is the consideration the entity expects to be entitled to in exchange for transferring the goods or services to the customer. Although straightforward for many entities, judgments will be needed related to variable consideration, such as discounts, rebates, royalties and other similar arrangements. FASB has introduced a constraint related to variable consideration, stating that it must be considered probable that a significant revenue reversal will not occur. There are also complexities related to the time value of money for payments expected to exceed one year, and non-cash consideration and the related fair value estimates of that non-cash consideration.
Step 4: Allocate the Transaction Price to the Performance Obligations
If a contract has more than one performance obligation, the entity should allocate the transaction price identified in step three to each performance obligation included in the contract. The entity must determine a standalone selling price related to the separate performance obligations and allocate the transaction price of the contract on a relative stand-alone selling price basis.
Step 5: Recognize Revenue When the Entity Satisfies a Performance Obligation
As performance obligations are satisfied, the entity will recognize the related revenue. In terms of a point of sale product or service, the performance obligation is satisfied upon transfer of the goods or performance of the service, and when the customer obtains control of that good or service. If the entity satisfies a performance obligation over time, an entity shall recognize the revenue over time by consistently applying a method of measuring the progress toward complete satisfaction of the performance obligation. The objective is to recognize the revenue consistent with the transfer of control to the customer.
Changes to Financial Statement Disclosures
Disclosures are required in order to provide the users of the financial statements with adequate information to assist them in understanding the nature, amount, timing and uncertainty of revenues and related cash flows arising from contracts with customers. Disclosures include both quantitative and qualitative information as follows:
1. Contracts with customers
- The amount of revenue recognized
- Disaggregation of the revenue recognized
- Information regarding performance obligations
- Transaction price allocated to remaining performance obligations (performance obligations not yet completed)
2. Significant estimates
- The timing of satisfaction of performance obligations (over time or point in time)
- Judgments related to determining the transaction price
- Judgments related to the amounts allocated to performance obligations
- Assets recognized from the costs to obtain or fulfill a contract
This Update is effective for annual reporting periods beginning after December 15, 2016 for public entities, including interim periods within that same reporting period. For non-public entities, the Update is effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Early adoption is not permitted for public entities. Non-public entities may apply the guidance for the annual reporting period beginning after December 15, 2016, consistent with public entities.
There are two methods available to an entity for applying the Update.
1. Full Retrospective Approach. The entity would apply the Update retrospectively to each prior period
presented and may elect any of the following practical expedients:
- For completed contracts, an entity need not restate contracts that begin and end within the same annual reporting period.
- For completed contracts that have variable consideration, the entity may use the transaction price at the date the contract was completed rather than estimating the variable consideration in the prior reporting periods.
- For reporting periods presented prior to the effective date of the Update, the entity need not disclose the amount of the transaction price allocated to the remaining performance obligations at the end of the reporting period. In addition, the entity need not disclose an explanation of when the entity expects to recognize that amount as revenue.
2. Retrospective with Cumulative Effect. The entity would recognize the cumulative effect of applying
this Update at the date of the application of the Update. In essence, the entity would opt to present
only the current year revenue under the new guidance. If the entity elects this method, it would need
to provide additional disclosures, including the amount each financial statement line item is impacted
in the current period by the application of the Update compared to the entity’s historical method of
recognizing revenue, and an explanation of the reasons for significant changes.
The implementation may take some time and level of effort on behalf of management depending on the revenue recognition policies currently in place. Some industries will be impacted more than others, such as construction, telecommunications, automotive and software. These industries have highly relied on industry specific guidance related to revenue recognition, which this Update supersedes.
The FASB has allowed for the time needed to implement the new guidance as evidenced by the effective dates, and there is flexibility related to the implementation approach. However, entities need to start planning now for this implementation. A thorough review of the company’s revenue recognition systems and controls is needed, and an implementation team and plan should be put in place.
In addition, be on the lookout for communications related to the Joint Transition Resource Group for Revenue Recognition. This group has been formed to inform the FASB and the IASB about potential implementation issues that could arise as the result of this new guidance. In addition, expect many public accounting firms and financial consultants to issue guidance related to the implementation of the new revenue recognition standards.
The full version of ASU 2014-09, Revenue from Contracts with Customers (Topic 606), can be downloaded at http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156316498