by Gary Lasker
October 1, 2018
The new revenue recognition standard will become effective for most entities in 2019. This new standard created a totally new accounting model for recognizing revenue. Its purpose is to standardize the way entities recognize revenue. Some entities may have insignificant changes as a result of this new standard while other entities may end up with a large impact upon adoption. However, almost all entities will have to deal with additional disclosure requirements.
There are some major changes between current accounting guidance and the new guidance. For instance, revenue is currently recognized when the transfer of risks and rewards of ownership occurs either at a point in time or over time. The new standard replaces this risk and rewards model with various transfer of control scenarios as the gauge to determine when revenue should be recognized. Another big change is the modification of the unit of accounting grouping used to account for revenue recognition. Units of account under which a transaction price and hence revenue are determined will be known as performance obligations. Performance obligations are analogous to deliverables or elements of a contract. Under the new revenue recognition standard, performance obligations may differ from the units of account used currently to account for and recognize revenue. Consequently, this could impact the amount and timing of revenue recognition which can affect key performance measures such as bank loan covenant ratios. Multiple performance obligations included in a contract will not be that unusual with the new separate unit of accounting criteria. As a final point, one of the pillars of revenue recognition in current revenue guidance is that the seller’s price to the customer is fixed or determinable. The new standard changes this by allowing for variable consideration which can accelerate revenue recognition in some circumstances.
Five-Step Revenue Recognition Model
The fundamental principle of the new standard is that an entity should recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration (payment) to which the entity expects to be entitled in exchange for those goods or services. To carry out this objective, the standard created a five-step model for most entities to follow when recognizing revenue:
• Identify the contract or contracts 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 entity satisfies a performance obligation.
Given the above framework, let us begin a brief review of the five-step process.
Step 1 – Identify the contract or contracts with the customer
The term contract, as defined by the Financial Accounting Standards Board, is an agreement between two or more parties that creates enforceable rights and obligations. The contracts can be written, oral, or electronically produced. Agreements do not have to be in writing to be considered a contract in the context of the pronouncement. The parties must have approved the contract and be committed to perform their acknowledged obligations.
Step 2 – Identify the performance obligations in the contract
Performance obligations are analogous to deliverables, elements, or components of a contract in the present guidance. Performance obligations are essentially what the entity is doing to earn the revenue. All arrangements will need to be analyzed to determine the goods and/or services the entity promises to transfer to a customer. An identification of all distinct performance obligations in an arrangement is a requirement in this step. In many cases, contracts will have more identified performance obligations that would be accounted for separately than under the existing revenue recognition rules.
Step 3 – Determine the transaction price
The transaction price is the amount of consideration (for example, payment) the entity expects to be entitled to for transferring the promised goods and services to its customers, excluding amounts collected on behalf of third parties. The transaction price could be fixed, variable, or even a combination of both. When the promised amount of consideration is variable, the transaction price is estimated using either the expected value method or the most likely amount method depending on which estimate is the better predictor of the consideration to which the seller is entitled. These methods provide estimates of the transaction price the entity would expect to receive. The amount of the resulting transaction price estimate should be only to the extent that it would be probable that a significant reversal of this estimate would not occur after the uncertainty related to the variable consideration is eventually resolved. Variable consideration can come from discounts, rebates, incentives, bonuses, and other like items. Businesses must also consider the effects of significant financing components and noncash payments when determining the transaction price.
Step 4 – Allocate the transaction price to the performance obligations in the contract
If a contract has more than one performance obligation, the seller allocates the transaction price to each performance obligation based on their relative standalone selling prices. The standalone selling price is the price at which the entity would sell a good or service separately to a customer. There are three suitable methods mentioned in the new standard to estimate standalone selling price if not observable. These three methods are the adjusted market approach, expected cost plus margin approach, and the residual method. Sometimes the transaction price has a discount or another form of variable consideration that relates to one or more of the performance obligations in a contract. Variable consideration would only be allocated to the performance obligations they are related to.
Step 5 – Recognize revenue when or as the entity satisfies a performance obligation
This is the last step in the five-step model. Under the new guidance, an entity should recognize revenue when or as it satisfies a performance obligation by transferring a good or service to a customer. A good or service is considered transferred when or as the customer obtains control over the good or service. Control by the customer would be attained either at a point in time or over time. It is up to the entity to evaluate whether the performance obligation is satisfied at a point in time or over time. Control in the new revenue recognition standard context is defined as the ability to direct the use of and obtain substantially all of the remaining benefits from the asset. Control would also include the ability to prevent other entities from directing the use of and getting benefits from the use of the asset. The new standard provides a list of transfer of control indicators which includes having legal title to an asset, having physical possession, and acceptance of the asset to name a few.
It should be no surprise to anyone that the new revenue recognition standard requires enhanced footnote disclosures. These disclosures are supposed to provide readers of financial statements with comprehensive information regarding the entity’s major revenue streams. Various disclosure requirements under the new standard include a.) Disaggregation of revenue into various categories [some examples are by major product lines, geographical, type of customer], b.) Disclosure of Contract balances and changes in the opening and closing balances during the reporting period, c.) Transaction prices allocated to the remaining performance obligations that are unsatisfied at the end of the reporting period, d.) Judgements made in applying the revenue recognition guidance, and e.) Information pertaining to performance obligations with the entity’s customers.
Some entities may find that following the five revenue recognition steps are easy and some entities may find those steps rather difficult to follow. When a fixed amount is received at the same time the transaction occurs, the transaction price is easy to establish. But when consideration is deemed variable and there are multiple performance obligations in a contract, recording the proper revenue amount is more difficult. The effort required to transition to the new standard should not be underestimated. Many new estimates and judgements must be made in order to comply with the five-step model. Thus, implementation of the new standard cannot start soon enough.