ASU 2014-09 – Revenue from Contracts with Customers is one of the most significant changes to the U.S. GAAP rules for revenue recognition in years.
In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued their much-anticipated converged standard on revenue recognition. The FASB issued Accounting Standards Update (ASU) No. 2014-09, and the IASB issued International Financial Reporting Standard (IFRS) 15, both titled “Revenue From Contracts With Customers.” With only minor differences, the joint standard represents a single, global, principles-based revenue recognition model. The new guidance will affect almost every entity that recognizes revenue from contracts with customers, so financial executives will need to determine how to apply the new standard.
Because the new standard is less prescriptive than FASB Accounting Standard Codification (ASC) 605, “Revenue Recognition,” financial executives will be required to use more of their own judgment than they do today. For many companies, the new standard might change the value and timing of revenue recognized. The effort required for a company to analyze and document revenue transactions is likely to increase, and the number of disclosures in the financial statements will grow as well.
Following is a discussion of the revenue recognition model, along with a description of significant issues a company might face when applying the new five-step approach. It is important for financial executives to keep these issues in mind when considering the impact the standard is likely to have on their organizations.
Step one: Identify the contract with a customer
Identifying the contract or contracts with a customer is the first step in the new framework for determining revenue recognition. Under existing guidance, persuasive evidence of an arrangement typically does not exist until both parties have signed a contract. The new standard indicates that contracts may be written, oral, or implied by an entity’s customary business practices as long as the contracts are enforceable by law.
This change could significantly affect any company that currently delivers goods or services to customers before a contract has been signed by both parties. Without an agreement signed by both parties, revenue recognition generally is prohibited under current guidance even if all other general revenue recognition criteria have been met. The new standard eliminates this distinction. As a result, companies will need to exercise more judgment when determining whether a contract with a customer is legally binding.
Step two: Identify each performance obligation in the contract
Identifying performance obligations in a contract, the second step in the new framework, is a significant change for companies. A performance obligation is a concept created by this new standard and is defined as a promise in a contract with a customer to transfer to the customer 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. However, companies will need to carefully review their contracts with customers to identify which promises meet the new standard’s definition of distinct.
Under the new standard, promised goods or services represent separate performance obligations if each one is distinct, meaning it meets both of the following criteria:
- 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 (that is, the good or service is capable of being distinct).
- 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 good or service is distinct within the context of the contract).
When a promised good or service is determined not to be distinct, entities will combine it with other goods or services until a distinct performance obligation can be identified.
Some companies and even whole industries may be affected by this requirement when performance obligations are identified that are different from their current policies surrounding deliverable elements to a customer. For example, an entity may have a performance obligation related to a “warranty” offered on its products, even though it does not recognize its warranty as a separate deliverable under current accounting rules.
Step three: Determine the transaction price
The change in how the transaction price is determined could be significant for companies that have variable payment arrangements.
Under the new standard, an entity will be required to determine the transaction price based on the amount of consideration to which it expects to be entitled, which may differ from the contract price.
The transaction price also may include variable consideration, such as contingent consideration due from the customer, consideration payable to the customer, and the time value of money for significant financing components. Under some contracts, the transaction price includes variable consideration such as rebates, price concessions, or discounts based on future actions. The new standard requires that any variable consideration be estimated at contract inception and that the amount of the consideration be included in the transaction price.
A limited exception to this variable consideration guidance under the new standard is that variable consideration related to sales or usage-based royalties on licenses of intellectual property should not be included in the estimate of the transaction price.
Step four: Allocate the transaction price to each performance obligation
Some arrangements typically include various performance obligations. As a result, the allocation of the transaction price to these separate performance obligations is important. The new standard changes the transaction price allocation process and indicates that the transaction price should be allocated to each separate performance obligation, generally in proportion to its stand-alone selling price – the price at which an entity would sell a good or service on a stand-alone basis at contract inception. Companies will need to take into account variable consideration, discussed in step three, and allocate any variable consideration to one or more of the performance obligations.
The new standard requires entities to use observable information, if available, to determine stand-alone selling prices. It discusses three estimation methods that entities will be able to use when stand-alone selling prices are not readily observable: 1) an adjusted market assessment approach, 2) an expected cost plus a margin approach, and 3) a residual approach.
Step five: Recognize revenue when or as each performance obligation is satisfied
Satisfying the performance obligations is the final step in the new revenue recognition framework. Under the new standard, revenue is recognized when an entity satisfies a performance obligation by transferring a promised good or service to the customer – that is, when the customer obtains control. The new standard also provides specific guidance to determine when control of distinct licenses of intellectual property transfer to customers.
Public companies must apply the new rules no later than the annual reporting periods beginning after Dec. 15, 2017, including interim reporting periods within that period. Private companies are required to apply the guidance no later than to annual reporting periods beginning after Dec. 15, 2018. Financial executives should begin the process of reviewing customer contracts now to understand the impact these new rules will have on their businesses in order to establish the processes, controls, and systems necessary to comply with these new rules.
To learn more, register for FEI’s CFRI conference November 14 and 15 to attend the Crowe Horwath LLP presentation on “Revenue Recognition Rules.” This session provides an overview of the guidance with a focus on those provisions likely to result in substantive changes from current U.S. GAAP rules. The discussion also includes an overview of the key phases to implementing the new standard, key steps in the process, and a session where panel members will be available for questions. This session is a great introduction for the Revenue Recognition session held later in the day.
Jim Hannan is a managing director with Crowe Horwath LLP, Glenn Richards is with Crowe Horwath LLP and Alex Wodka is a partner with Crowe Horwath LLP.•