Accounting for Revenue Recognition Will be Changing Soon
After nearly 13 years of work, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) issued their converged standard on revenue recognition on May 28. The objective of the new revenue standard is to provide a comprehensive revenue recognition model that improves the consistency and comparability of revenue recognition within and across industries and to provide more useful information to investors through new disclosure requirements. The new standard supersedes a majority of existing revenue recognition guidance within U.S. generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS), and will affect almost all entities.
The standard will take effect for fiscal years beginning after December 15, 2016 for public entities or December 15, 2017 for private entities. While this seems like a long time into the future, most companies will find it will take a significant effort to make a change in their method of revenue recognition, so we strongly recommend that companies start their process for evaluation soon.
The new guidance requires retrospective presentation, which may be fully retrospective or a modified retrospective approach, for all periods presented.
Under the full retrospective approach, companies will be able to apply the new revenue standard to each period presented in the financial statements. This means companies will have to apply the new revenue standard as if it had been in effect since the inception of all its contracts with customers.
Under the modified retrospective approach, companies will apply the new revenue standard retrospectively only to the most current period in the financial statements with an adjustment to the opening balance of retained earnings to recognize the cumulative effect of applying the new standard.
Under the new revenue standard, the revenue recognition model uses a five-step, principles-based approach versus the currently existing rules-based approach that is largely based on achieving hurdles, combined with a plethora of industry- and transaction-specific accounting literature.
The new revenue standard’s five-step approach is as follows:
- Identify the contract with the customer;
- Identify the performance obligations in the contract;
- Determine the transaction price;
- Allocate the transaction price to the performance obligations in the contract;
- Recognize revenue when (or as) the reporting organization satisfies a performance obligation.
The new revenue standard will be applied to all contracts with customers excluding lease contracts, insurance contracts, financial instruments, non-monetary exchanges and certain guarantees.
Under the new revenue standard, contracts are agreements between parties that create enforceable rights and obligations and can be written, oral, or implied by an entity’s normal business practices. Prior to recognizing revenue, the parties must:
- Approve the contract
- Identify rights regarding the goods and services
- Identify payment terms
- Determine the commercial substance of the arrangement
- Determine that the entity will collect the consideration
- Companies will be required to reassess their customer contracts at each reporting period to determine if their customer arrangements meet each criteria before revenue can be recognized.
The new revenue standard defines a performance obligation as a promise to transfer a distinct good or service (or a series of distinct goods or services that are substantially the same and have the same pattern of transfer) to a customer. Companies will have to carefully evaluate each of their customer contracts and identify whether multiple performance obligations exist. For example, an industrial equipment manufacturer that promises to build, install, service and offer an extended warranty as part of a single arrangement may have multiple performance obligations that may lend itself to various revenue recognition patterns as each performance obligation is met.
The new revenue standard defines that 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. To determine the appropriate transaction price, companies will be required to evaluate their customer contracts for potential variable consideration, non-cash consideration, consideration payable to a customer, or a significant financing component.
After the transaction price has been determined, companies will be required to allocate the total transaction price to each performance obligation based on the relative standalone selling prices of each performance obligation. The allocation is required to be made at each contract’s inception, and is not adjusted to reflect subsequent changes to standalone selling prices of each performance obligation. Under the new revenue standard, companies will have to carefully determine standalone selling prices for each performance obligation extended to their customers. In the event the company does not have an observable standalone selling price (since performance obligations may always be bundled within a single contract), companies will be required to estimate the selling price.
Control of goods
As companies transfer the control of goods or services to their customer, revenue recognition will be permitted. Control refers to the customer’s ability to direct the use of the good or service and obtain substantially all the remaining benefits. This concept is fundamentally different than the currently existing revenue guidance, in which revenue is recorded upon transfer of risk and rewards. Under the new guidance, it would be permissible for companies to recognize revenue at the transfer of control and retain economic risk. If companies extend performance obligations that are satisfied over time, then revenue will be recorded as the customer concurrently receives and consumes the benefits provided by the performance obligation.
The required footnote disclosures have also been expanded under the new revenue standard. The new disclosures will require more robust qualitative and quantitative information than the existing revenue standard. New disclosures that will be added as a result of changes to the revenue recognition model will include disclosure of contract assets and liabilities, the nature and type of performance obligations the company extends to customers, and information about remaining or unearned performance obligations at each reporting period.
Conclusions and Next Steps
It will be important for companies to begin the process of determining the impact of the new revenue standard as soon as possible. Once companies evaluate the impact of the new revenue standard on their business, accounting, and financial reporting processes, a transition approach should be developed that will be followed by a structured implementation process. Depending on the impact of the new revenue standard on the company’s business, IT systems, automated and manual processes, internal controls and personnel changes could all be necessary in order to capture the required financial information and adhere to the requirements of the new revenue standard.
We expect that substantially all industries will be impacted by the new standard; however the industries that will be most heavily impacted by the new revenue standard include engineering and construction, software and technology, communications and even industrial products.
BMF is here to help you as you start the process of looking at what your company will need to do in changing your methods of revenue recognition.
Eric D. German?>
James E. Merklin?>
CPA/CFF, CFE, CGMA, MAcc
About the Authors
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