Background and Overview
Existing U.S. GAAP is complex, very detailed and contains numerous revenue requirements for particular industries or transactions, which sometimes results in different accounting for economically similar transactions. The new standard aims to improve GAAP by removing inconsistencies from existing requirements, increasing information disclosed to users of financial statements and improving comparability across companies, industries and geographical regions. This ASU supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry specific guidance and also supersedes some cost guidance included in Subtopic 605-35, Revenue Recognition—Construction-Type and Production-Type Contracts. In addition, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer (e.g., assets within the scope of Topic 360, Property,Plant and Equipment, and intangible assets within the scope of Topic 350, Intangibles—Goodwill and Other) are amended to be consistent with the guidance on recognition and measurement (including the constraint on revenue) in this ASU.
Companies involved in multiple element transactions may be impacted the most under the new guidelines through significant changes in the amounts and timing of revenue recognition. The FASB has indicated that companies in the software, telecommunications, and real estate industries in many cases are likely to recognize revenue earlier under the new standard.
The core principle of the guidance is that an entity should recognize revenue from contracts with customers when the entity transfers promised goods or services to the customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve the core principle, an entity should apply the following five steps:
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
This core principle replaces the four required revenue recognition criteria and multiple element arrangement accounting under current guidance. A brief summary of each of the above steps is included below:
Step 1: Identify the Contract with a Customer
A contract is an agreement between two or more parties that creates enforceable rights and obligations. In some cases, an entity should combine contracts and account for them as one contract. In addition, there is guidance on the accounting for contract modifications.
Step 2: Identify the Performance Obligations in the Contract
A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. If an entity promises in a contract to transfer more than one good or service to the customer, the entity should account for each promised good or service as a performance obligation only if it is distinct or a series of distinct goods or services that are substantially the same and have the same pattern of transfer. 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
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. The consideration recognized includes evaluating attributes such as variable pricing, collectability, discounts over time, non-cash receipts and payables to customers that may be used to offset receivables. Estimated variable consideration should be included only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
An entity will typically allocate the transaction price to each performance obligation in a contract on the basis of the relative standalone selling price of each distinct good or service promised in the contract. If a standalone selling price is not observable, an entity must estimate it. The guidance specifies when an entity should allocate a discount or variable consideration to one (or some) performance obligation(s) rather than to all performance obligations in the contract and when the residual approach is permitted to allocate the consideration.
Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation
Revenue is recognized as contracted performance obligations are satisfied which can be at one point in time or over a specified period if a performance obligation is satisfied continuously over time, depending on the nature of the contract.
Revenue is recognized at one point in time when indicators of control indicate that the customer has
received control of the asset. Indicators include the entity having a right to payment, transfer of legal title to the customer, physical possession of the asset by the customer, risks and rewards of ownership of the asset passing to the customer and acceptance by the customer.
Alternatively, revenue is recognized over a specified period if one of the three following criteria is met:
1.The entity creates or enhances an asset (e.g.: work in process) that is controlled by the customer during the performance period.
2.The entity’s performance does not create an asset with alternative use, the entity expects to fulfill the contract as promised and the entity has an enforceable right to payment for performance completed to date.
3.The customer is receiving and consuming the benefits of the entity’s performance as the entity performs the service evidenced by the fact that a different company would not have to re-perform work completed to date if engaged to fulfill outstanding services.
Where one of these criteria is met, the entity will select a measure of progress for the contract requirements to recognize revenue which best depicts the transfer of benefits to the customer. Appropriate measures include output methods (examples include surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units produced/delivered) and input methods (examples include resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used). As circumstances change over time, an entity should update its measure of progress to depict the entity’s performance completed to date.
The guidance also addresses the accounting for:
• Contract modifications
• Principal versus agent considerations
• Customer options for additional goods and services
• Non-refundable upfront fees
• Repurchase agreements
• Bill and hold arrangements
Costs to Obtain or Fulfill a Contract with a Customer
An entity should recognize as an asset the incremental costs of obtaining a contract (i.e. commissions paid or payable) that the entity expects to recover; however, these costs may be expensed when incurred if the amortization period is one year or less.
An entity should apply the requirements of other standards, if applicable, for the costs of fulfilling a contract with a customer. Examples include standards related to inventory, internal-use software, property, plant, and equipment and costs of software to be sold, leased, or marketed. Otherwise, an entity should also recognize an asset for the costs to fulfill a contract if those costs relate directly to a contract (or a specific anticipated contract), generate or enhance resources of the entity that will be used in satisfying performance obligations in the future and are expected to be recovered.
The ASU requires an entity to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Qualitative and quantitative information is required about:
1.Contracts with customers - including revenue and impairments recognized, disaggregation of revenue, and information about contract balances and performance obligations (including the transaction price allocated to the remaining performance obligations).
2.Significant judgments and changes in judgments - determining the timing of satisfaction of performance obligations (over time or at a point in time), and determining the transaction price and amounts allocated to performance obligations.
3.Assets recognized from the costs to obtain or fulfill a contract.
The specific disclosures required under the new guidance are included in the ASU. Nonpublic entities may elect not to provide certain of the specific required disclosures as permitted in the ASU.
For a public entity, the guidance in the ASU is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Public entities who report on a calendar year basis will be required to apply the standard starting in the first quarter of 2017. Early application is not permitted.
For nonpublic entities, the new guidance is effective for annual reporting periods beginning after December 15, 2017, and interim and annual periods beginning after those reporting periods. A nonpublic entity may elect early adoption but no earlier than the effective date for public entities.
An entity should apply the amendments in this ASU using one of the following two methods:
1. Retrospectively to each prior reporting period presented and the entity may elect any of the following practical expedients:
a) For completed contracts, an entity need not restate contracts that begin and end within the same annual reporting period.
b) For completed contracts that have variable consideration, an entity may use the transaction price at the date the contract was completed rather than estimating variable consideration amounts in the comparative reporting periods.
c) For all reporting periods presented before the date of initial application, an entity need not disclose the amount of the transaction price allocated to remaining performance obligations and an explanation of when the entity expects to recognize that amount as revenue.
2. Retrospectively with the cumulative effect of initially applying this ASU recognized at the date of initial application. If an entity elects this transition method it also should provide the additional disclosures in reporting periods that include the date of initial application:
a) The amount by which each financial statement line item is affected in the current reporting period by the application of this ASU as compared to the guidance that was in effect before the change.
b) An explanation of the reasons for significant changes.
Impact on Your Company and Suggested Actions
Early assessment of the impact of the guidance on your organization will allow for a smoother transition. The impact will be the greatest for entities that currently follow industry-specific guidance, have multiple element arrangements and those that enter into certain royalty or licensing arrangements. Companies should gain a baseline understanding of the effect of the new principles and start to identify performance obligations in contracts with customers, understand which contract costs relate to which performance obligations, and give significant consideration to variable pricing and the ability to make reliable estimates over those amounts which will not be subject to future reversal. In addition, allocation of the transaction price to the underlying performance obligations will require the determination of the standalone selling price as discussed earlier and may require significant judgment and estimates. Companies should implement systems to track revenue recognition differences for their contracts over the years to implementation.
Estimates of revenues under the new guidance should be compared to current and forecasted revenues recognized. Key financial ratios can be recalculated using the new estimates to gain an understanding of the impact at a summary level. Disclosures of the impact of the ASU will be required in upcoming SEC filings for public companies and nonpublic companies should also consider disclosures so that stakeholders understand the impact of the new rules. The adoption of the guidance may also impact taxes, debt covenants, bonus arrangements and other key metrics.
The ASU will require significant estimates and judgments relating to the determination of the transaction price, allocation to the performance obligations and recognition of the revenue, as well as increased disclosures. Governance committees should understand the significant estimates and judgments and related internal controls, impact on key metrics, and the financial statement changes. Companies may potentially need to make changes to financial reporting internal controls and/or accounting processes, sales contract formats and training for sales and financial personnel as a result of the implementation.
In June 2014, the FASB and IASB announced the formation of the Joint Transition Resource Group for Revenue Recognition (TRG). The TRG will inform the IASB and the FASB about potential implementation issues that could arise when companies and organizations implement the new standard. The TRG will also provide stakeholders with an opportunity to learn about the new standard from others involved with implementation. The TRG will not issue guidance.
Members of the TRG include financial statement preparers, auditors and users representing a wide spectrum of industries, geographical locations and public and private companies and organizations. The TRG will meet publicly until the new standard goes into effect.
More information about the TRG, including instructions for submitting a potential implementation issue, is available on the FASB’s website.
Examples Included in ASU
The new ASU includes examples of the hypothetical application of the guidance to different situations. Below are three of these examples extracted directly from the guidance that may be applicable to your company.
Example of Identifying Contract and Determining Transaction Price:
Example 2 in ASU:
An entity sells 1,000 units of a prescription drug to a customer for promised consideration of $1 million. This is the entity’s first sale to a customer in a new region, which is experiencing significant economic difficulty. Thus, the entity expects that it will not be able to collect from the customer the full amount of the promised consideration. Despite the possibility of not collecting the full amount, the entity expects the region’s economy to recover over the next two to three years and determines that a relationship with the customer could help it to forge relationships with other potential customers in the region. Based on the assessment of the facts and circumstances, the entity determines that it expects to provide a price concession and accept a lower amount of consideration from the customer. Accordingly, the entity concludes that the transaction price is not $1 million and, therefore, the promised consideration is variable. The entity estimates the variable consideration and determines that it expects to be entitled to $400,000.
The entity considers the customer’s ability and intention to pay the consideration and concludes that even though the region is experiencing economic difficulty it is probable that it will collect $400,000 from the customer. Consequently, the entity concludes that the criterion in paragraph 606-10-25-1(e) is met based on an estimate of variable consideration of $400,000. In addition, based on an evaluation of the contract terms and other facts and circumstances, the entity concludes that the other criteria in paragraph 606-10-25-1 are also met. Consequently, the entity accounts for the contract with the customer in accordance with the guidance in this Topic.
Example of Identifying Performance Obligation- Goods and Services Not Distinct:
Example 10 in ASU:
An entity, a contractor, enters into a contract to build a hospital for a customer. The entity is responsible for the overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing.
The promised goods and services are capable of being distinct as the customer can benefit from the goods and services either on their own or together with other readily available resources. This is evidenced by the fact that the entity, or competitors of the entity, regularly sells many of these goods and services separately to other customers. In addition, the customer could generate economic benefit from the individual goods and services by using, consuming, selling, or holding those goods or services. However, the goods and services are not distinct within the context of the contract as the entity’s promise to transfer individual goods and services in the contract are not separately identifiable from other promises in the contract. This is evidenced by the fact that the entity provides a significant service of integrating the goods and services (the inputs) into the hospital (the combined output) for which the customer has contracted.
Because both criteria in paragraph 606-10-25-19 are not met, the goods and services are not distinct. The entity accounts for all of the goods and services in the contract as a single performance obligation.
Example of Identifying Performance Obligations - Determining Whether Goods or Services Are Distinct:
Example 11 in ASU:
Case A—Distinct Goods or Services
An entity, a software developer, enters into a contract with a customer to transfer a software license, perform an installation service, and provide unspecified software updates and technical support (online and telephone) for a two-year period. The entity sells the license, installation service, and technical support separately. The installation service includes changing the web screen for each type of user (for example, marketing, inventory management, and information technology). The installation service is routinely performed by other entities and does not significantly modify the software. The software remains functional without the updates and the technical support.
The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity observes that the software is delivered before the other goods and services and remains functional without the updates and the technical support. Thus, the entity concludes that the customer can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available and the criterion in paragraph 606-10-25-19(a) is met.
The entity also considers the factors in paragraph 606-10-25-21 and determines that the promise to transfer each good and service to the customer is separately identifiable from each of the other promises (thus, the criterion in paragraph 606-10-25-19(b) is met). In particular, the entity observes that the installation service does not significantly modify or customize the software itself, and, as such, the software and the installation service are separate outputs promised by the entity instead of inputs used to produce a combined output.
On the basis of this assessment, the entity identifies four performance obligations in the contract for the following goods or services:
a) The software license
b) An installation service
c) Software updates
d) Technical support
The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether each of the performance obligations for the installation service, software updates, and technical support are satisfied at a point in time or over time. The entity also assesses the nature of the entity’s promise to transfer the software license in accordance with paragraph 606-10-55-60 (see Example 54 in paragraphs 606-10-55-362 through 55-363).
Case B—Significant Customization
The promised goods and services are the same as in Case A, except that the contract specifies that, as part of the installation service, the software is to be substantially customized to add significant new functionality to enable the software to interface with other customized software applications used by the customer. The customized installation service can be provided by other entities.
The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity observes that the terms of the contract result in a promise to provide a significant service of integrating the licensed software into the existing software system by performing a customized installation service as specified in the contract. In other words, the entity is using the license and the customized installation service as inputs to produce the combined output (that is, a functional and integrated software system) specified in the contract (see paragraph 606-10-25-21(a)). In addition, the software is significantly modified and customized by the service (see paragraph 606-10-25-21(b)). Although the customized installation service can be provided by other entities, the entity determines that within the context of the contract, the promise to transfer the license is not separately identifiable from the customized installation service and, therefore, the criterion in paragraph 606-10-25-19(b) (on the basis of the factors in paragraph 606-10-25-21) is not met. Thus, the software license and the customized installation service are not distinct.
As in Case A, the entity concludes that the software updates and technical support are distinct from the other promises in the contract. This is because the customer can benefit from the updates and technical support either on their own or together with the other goods and services that are readily available and because the promise to transfer the software updates and the technical support to the customer are separately identifiable from each of the other promises.
On the basis of this assessment, the entity identifies three performance obligations in the contract for the following goods or services:
a) Customized installation service (that includes the software license)
b) Software updates
c) Technical support
The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether each performance obligation is satisfied at a point in time or over time.
Questions? Contact: Dave Porter, firstname.lastname@example.org, 503-445-3417
Article originally published in Accounting and Financial Reporting Developments - EKS&H 2014 Summer Quarter Update. Written by the Technical Accounting and Advisory Group (TAAG) at EKS&H. For more information, please contact Brent Peterson at email@example.com or Diane Kirk at firstname.lastname@example.org or 303.740.9400.