By now, virtually everyone involved in accounting – on both provider and client sides – is familiar with ASC 606, Revenue From Contracts With Customers. Issued jointly by the FASB and IASB in 2014, it overhauls the existing revenue recognition model for all entities and establishes new guidelines designed to standardize and improve financial reporting. The changes take effect beginning in 2019 for non-public companies.
The topic is particularly important today because for many entities, revenue is the single largest amount in their financial statements. Management, lenders, shareholders, and other financial statement users focus on revenue to monitor an entity’s financial performance and general financial health.
There are two key principles under the new revenue standard: 1) Revenue should be recognized in a way that reflects the transfer of promised goods or services; and 2) The amount of revenue recognized should equal the consideration to which an entity is entitled for those promised goods or services.
Prior to the change, accounting utilized more of a rules-based approach to revenue recognition, in which revenue was recognized if certain rules were met. In contrast, the new principles-based approach simplifies the process by reducing the number of requirements to which an entity must refer and calls for more judgment to be applied when considering certain matters.
The new standard establishes a five-step approach for recognizing and measuring revenue.
1) Identify customer contracts.
Contracts with customers don’t have to be written. By definition, a contract exists when there is an enforceable agreement between parties. It could be a verbal agreement or come in the form of a written purchase order. Much depends on established business practices in a given industry.
2) Identify performance obligations.
A performance obligation is a contractual promise to transfer distinct goods or services to a customer. Examples include one-time barber services or recurring consulting services.
In a standard retail store transaction, the performance obligation of the retailer is to provide the goods that a customer wants to purchase, such as a hammer. In the manufacturing industry, it may be a one-time obligation, such as fulfillment of a customer purchase order. In a service industry, the performance obligation may be a one-time obligation like preparing a tax return, or a continuing service, such as providing regular housecleaning for the duration of a year.
3) Determine the transaction price.
The transaction price is the amount that ultimately will be recognized as revenue. It can be a fixed amount, or it may include variable consideration such as discounts, rebates, price concessions, incentives, penalties, etc. The consideration may be stated in cash, or it may include noncash items, such as shares of stock. If variable or noncash consideration is involved, significant judgment will be needed to estimate the transaction price.
Variable consideration depends on the occurrence of a future event, such as a performance bonus earned if and when a deadline is met. To determine the transaction price, a company will use the best estimate of the variable (undetermined) consideration to which the company will be entitled. It is not necessary to wait for the uncertainty to be resolved before starting to recognize it, which means that revenue may be recognized earlier than when it was under the prior accounting rules.
The bottom line is that effects of variable consideration, the time value of money, and noncash consideration all need to be considered when determining the transaction price.
4) Allocate the transaction price to the performance obligations.
Revenue is earned when a performance obligation is satisfied – that is, when a customer gets control of the goods or services that make up the performance obligation.
A transaction price is allocated to each of the performance obligations so that the company knows how much revenue it is entitled to recognize when an obligation is satisfied. If a contract has only one performance obligation, the entire transaction price can be attributed to that performance obligation. When there is more than one performance obligation, the transaction price must be allocated to all of them.
To allocate the transaction price, first determine the standalone selling prices of the goods and services. Then, add up the standalone selling prices that make up each performance obligation and calculate an allocation ratio based on these totals. Lastly, allocate the transaction price based on the ratios.
5) Recognize revenue when performance obligations are satisfied.
To repeat: the performance obligation is satisfied when the customer assumes control of the related goods or services. Control can be transferred over time (which might be typical for a service or construction contract) or at a specific point in time (such as in a retail transaction).
Revenue is recognized by measuring the progress toward satisfying the performance obligation. A company is required to choose the method that best represents the transfer of goods or services; it could be an input measurement (costs incurred to total expected costs) or an output (quantity of widgets produced to total widgets).
If a company is unable to reasonably measure progress, then it should recognize revenue only to the extent of costs incurred. The existing completed-contract method is no longer allowed under the new guidance.
Implementation of FASB ASC 606 requires some degree of retrospective adoption. This may be done in one of two ways:
1) Full retrospective adoption
If full retrospective adoption is selected, the financial statements are presented as if the new guidance has been applied to all contracts presented in the financial statements since the inception of those contracts. For a nonpublic entity that presents current year and prior year comparative financial statements, the guidance would have to be applied as of the beginning of the earlier year. There are, however, a few practical expedients that are permitted. For example, it is not necessary to restate completed contracts that begin and end in the same annual reporting period. Another example: for contracts that include variable consideration, the actual, rather than the estimated, consideration may be used to determine the contract’s transaction price in the comparative reporting periods.
2) Modified retrospective adoption (with cumulative effect adjustment)
If the modified retrospective approach is selected, the guidance is applied as of the beginning of the current year and then to subsequent periods. The prior periods presented in the financial statements, if any, are not restated. Retroactive guidance is applied only to contracts that are not completed at the date of initial application; those contracts must be evaluated as if the requirements had been applied since the inception of the contracts. The cumulative effect is then recognized as an adjustment to beginning retained earnings.
However, it is important to note that this approach requires the company to disclose the amount that each line item is affected in the current period by applying the new guidance rather than prior accounting rules. Thus, it is necessary to maintain accounting records under both the new accounting guidance and previous accounting rules during the initial year of adoption.
For some entities, responsibility for FASB ASC 606 implementation may be assigned to an individual, while others may designate a cross-functional team. Either way, this person or group will become the company’s expert on revenue and take the lead throughout the transition. That said, it is important to make sure both management and employees throughout most departments are aware of the new guidance and what is needed to implement it.
Next, the transition leaders will need to carefully consider the entity’s operations and financial statements to assess the potential effects of the implementation. They must consider existing contracts and identify any contract features or terms that may require additional analysis, such as contracts that include both goods and services to identify the separate performance obligations. It is also important to identify the key estimates and judgments that need to be made.
Implementation may require a company to make changes to operations, IT systems, processes, and internal controls, so it is important to identify necessary changes as early as possible to allow time for revisions to be made and adequately tested. At some point before implementation, it will be necessary to train staff that will be involved and those whose job responsibilities will change.
Finally, it is important to discuss the expected changes with stakeholders and anyone else who uses the financial statements. For some entities, the accounting changes will be minimal and only new disclosures will be required. For others, however, significant accounting and reporting changes may be needed, as well as the new disclosures.
By now, it should be clear that the new revenue recognition guidance will have far-reaching effects for virtually every American business. We welcome the opportunity to discuss how the new standard may affect your firm, beginning with financial reporting for 2018 and 2019 and any implementation concerns or questions you may have. Contact our Audit & Assurance Services Team.