Back in August, we discussed the new accounting requirements under ASC 606, Revenue from Contracts with Customers, and how they affect companies’ financial reporting in 2018 and 2019. In this article, we will illustrate how this accounting standard may affect your company.
The new standard establishes a five-step approach for recognizing and measuring revenue:
1) Identify customer contracts.
2) Identify performance obligations.
3) Determine the transaction price.
4) Allocate the transaction price to the performance obligations.
5) Recognized revenue when performance obligations are satisfied.
Below, we examine each step in detail.
Step 1 – Identify customer contracts.
A contract exists when there is an enforceable agreement between parties. This means that a) the parties have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations; b) each party has rights regarding the goods or services to be transferred; c) payment terms for the goods or services to be transferred are identified; and d) the contract has commercial substance – that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract.
In addition, a contract exists only when the entity believes it will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Example: A customer has had slow payments in the past with the company who then offers price concessions.
In this example, the company agrees to continue selling its services to the customer despite their lack of timely payments in the past. A condition to this continuing business is to request a 50% deposit on future services, with the remaining amount due following the regular trade terms.
Because there is doubt that the customer can pay for all services, no valid contract exists, and therefore no revenue will be recorded until the determination is made by management that the customer can pay for the services. Any deposit received will be recorded on the balance sheet as a customer deposit liability.
Example: A customer contract is to purchase 10,000 items for $10 each. After some time has elapsed, the customer wishes to purchase an addition 10,000 items, but the price has now increased to $12 each.
In this example, a) the scope of the contract increases because of the addition of promised goods or services that are distinct; and b) the price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services. Because both ‘a’ and ‘b’ were met, the additional 10,000 items will be considered a separate contract, and accounted for separately.
To contrast this, if we assume the first 10,000 items had a minor defect, and that the company offered the next 10,000 items at a discount of $8 each as compensation, management would conclude that the discounted unit price does not represent the standalone selling price, and therefore does not create a new contract – rather this is a modification of the existing contract. The company would then record revenue of $9 per unit for each unit sold – i.e. 20,000 units / total expected revenue of $180,000.
Step 2 – Identify performance obligations.
A performance obligation is a contractual promise to transfer distinct goods or services to a customer, and is identified if both of the following are true: a) 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 b) The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract –that is, the promise to transfer the good or service is distinct within the context of the contract.
Example: A company has entered into a contract to build a piece of manufacturing equipment, install the equipment, and train the customer’s employees on using the equipment.
For this example, let’s say the customer is building a CNC machine. This machine is not customized for the customer and therefore could be installed by a third party, and the training could be performed by a third party as well. This would constitute three distinct performance obligations, because the customer can benefit from each good or service on its own, and they are separately identifiable in the contract.
Now let’s say that this is a customized piece of equipment, using proprietary technology only available to the company. If the company would be required to install the equipment so that it integrates properly with the customer’s workshop, then those two performance obligations would be combined because the customer could not benefit from the equipment without the specialized installation provided by the company. But the equipment training would be a distinct performance obligation if it could be provided by a third party.
Step 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, and penalties. Management’s best estimates will be used to determine the amount of variable consideration to be received by the company.
Example: The company is building the piece of manufacturing equipment discussed in Step 2 above. Since it will also provide installation and training, management has determined the transaction involves three separate performance obligations. The contract totals $150,000, plus a $25,000 performance bonus if completed within 60 days, and a discount on training of $1,000 per day (up to 3 days) if training is completed efficiently.
In this example, management will evaluate the likelihood of each variable.
First, they will consider the performance bonus – they will either receive it or they will not, so management elects the ‘most likely amount method.’ Management has the capacity to build the equipment and determined it has a 75% chance of receiving the bonus.
Next, management will consider the training discount. The length of training varies from customer to customer, but by examining their historical records, management is able to estimate the following likelihood:
10% 5 days of training (no discount)
30% 4 days of training ($1,000 discount)
30% 3 days of training ($2,000 discount)
30% 2 days of training ($3,000 discount)
Management elects the ‘expected value method.’ Using the weighted average of the statistics above, the expected value of the discount is determined to be $1,800.
Thus, the transaction price of this contract is $173,200 ($150,000, plus $25,000 bonus, less $1,800 expected value of discount)
Step 4 – Allocate the transaction price to the performance obligations.
The 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. When there is more than one performance obligation, the transaction price must be allocated to all of them.
Example: Continuing the example from Step 3 above, the transaction price of the contract is determined to be $173,200. Management identified the standalone selling price for each performance obligation as listed below. This is based on observable inputs whenever possible, but management can use other information as needed to determine the values.
Equipment $125,000 83.3%
Installation $15,000 10.0%
Training $10,000 6.7%
TOTAL $150,000 100%
Management determines that the performance bonus should be allocated specifically to the equipment, and the training discount specifically to training. In other situations, management may allocate variable consideration proportionately among all performance obligations.
The transaction price would be identified as follows for the performance obligations:
Step 5 – Recognize revenue when performance obligations are satisfied.
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).
An entity transfers control of a good or service over time if one of the following criteria is met:
a) The customer simultaneously receives and consumes the benefits provided by the entity’s performance.
b) 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.
c) 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 those three criteria is met, then the entity transfers control at a specific point in time.
Example: Let’s complete the example described in Steps 2-4 above. Management has determined the performance obligations transfer control of the goods and services as follows:
Equipment – Control is transferred over time, as the company is building this equipment specifically for this customer and would not be able to sell to any other customer. The company will use the input method to determine progress of this performance obligation, and determines that labor hours are the best measure to determine progress. The company will recognize a portion of revenue related to the $150,000 allocated to the equipment based on a proportion of actual labor hours to total labor hours expected in construction.
Installation – Control is transferred at a specific point in time, since installation does not meet any of the criteria described above. The company concludes that it needs to complete the installation process for the customer to have received control of the performance obligation; therefore, it will record $15,000 upon completion of the installation.
Training – Again, control will be transferred at a specific point in time. The company concludes that it needs to complete all training for the customer to have received control of the performance obligation, and therefore will record $8,200 upon completion of the training.
These examples are offered to help you understand how the new revenue recognition standard may apply to your company. If you’d like further explanation or have specific questions, please contact our Audit & Assurance Services Team.