United States accounting principles require the adoption of a new standard on revenue recognition for periods beginning on or after December 15, 2018. The new standard supersedes the former guidance and most industry specific guidance to remove inconsistencies, improve comparability between companies and industries and to provide guidance in revenue recognition matters. The new standard describes what it takes to form a contract with a customer and provides guidance on when to consider contract modifications a separate contract. It also provides criteria to consider when determining if control over a good or service has been transferred.
Some of the primary differences from the previous accounting rules are that the selling price doesn’t need to be reasonably assured to recognize revenue, the selling price can be variable and can be estimated. Additionally, revenue is now recognized upon the transfer of control of a good or service to a customer, rather than upon the transfer of the risks and rewards of ownership to the customer. The new standard also introduces the concepts of separate performance obligations and distinct goods and services.
To determine when to recognize revenue a five step process must be considered:
Step 1 – Identify the contract with the customer
Apply the new revenue recognition model to a contract if all of the following criteria are met:
1. The parties to the contact have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations.
2. The entity can identify each party’s rights regarding the goods or services to be transferred.
3. The entity can identify the payment terms for the goods or services to be transferred.
4. 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).
It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Step 2 – Identify the performance obligations in the contract
A performance obligation is a promise to transfer either a good or service that is distinct or a series of distinct goods or services that are substantially the same. Distinct is defined as:
1. Customer can benefit from the good or service either on its own or with other resources readily available, and
2. Promise to transfer the good or service is separately identifiable from other promises in the contract.
Lack of distinction may result in a single performance obligation. Performance obligations can either be satisfied at a point in time or over time.
Step 3 – Determine the transaction price
Consideration promised in a contract with a customer may include fixed amounts, variable amounts or both. When determining the transaction price, an entity should consider the effects of:
1. Variable consideration (if estimable) – consideration may vary due to rebates, discounts, incentives, penalties or other items.
2. Existence of a significant financing component – based on time value of money when payments are over an extended period of time.
Step 4 – Allocate the transaction price
1. The standalone selling price should be used to allocate the transaction price to each identified performance obligation. If the total of each standalone selling price exceeds the transaction price, the discount is to be assigned to a specific performance obligation if identifiable. Otherwise, an allocation must be determined.
2. If the standalone selling price isn’t directly observable it should be estimated.
3. Allocation of variable consideration may also need to occur.
Step 5 – Recognize revenue when or as the entity satisfies a performance obligation
Revenue is recognized upon transfer of goods or services. Transfer occurs when customer gains control, either at a point in time or over time.
1. Consider the following indicators for transfer of control at a point in time:
- Entity has present right to payment, generally due to customer having obtained the ability to direct the use of the asset.
- Customer has legal title to the asset.
- Entity has transferred physical possession of the asset.
- Customer has the significant risks and rewards of ownership.
- Customer has accepted the asset.
2. Transfer of control over time, thus satisfying a performance obligation over time, occurs if any of the following are met:
- Customer receives and consumes the benefits as the entity performs.
- Entity performance creates or enhances an asset the customer controls.
- Entity performance does not create or enhance an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
3. If cash is received and there is not a contract, revenue can be recognized if one of the following is met:
- The order has been terminated and consideration received is nonrefundable.
- Goods or services have been transferred, and consideration has been received and is nonrefundable.
When these five steps are followed, the new standard may change when and how revenue is recognized in the following situations.
1. If a company provides a customer with multiple goods or services under one contract, such as selling multiple products or providing a service along with a product, the company must account for each distinct product or service separately rather than as just one transaction. This may change the timing and amount of revenue that is recognized if company previously considered multiple performance obligations to be a single transaction. Companies that currently recognize all the revenue at the beginning of a transaction and accrue a liability for future costs will probably need to change their methodology.
2. The allocation of discounts, rebates and other incentives given to customers are reflected as a reduction of revenue and may be allocated differently under the new standard.
3. If a company offers a warranty separately, then the warranty is treated as a performance obligation and revenue is assigned to the warranty and recognized over the warranty period.
4. The percentage of completion method is replaced with recognizing revenue over time. One of the following criteria must be met for a company to recognize revenue over time
- Customer receives and consumes the benefits as the entity performs.
- Entity performance creates or enhances as asset the customer controls.
- Entity performance doesn’t create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
- Revenue for the sale of intellectual property can be recognized either over time or at a point in time, depending on the specific facts of the situation.
The new revenue recognition standard will probably not change anything for a typical manufacturing company that records revenue when it ships products. A typical service company that recognizes revenue as it performs services also will probably not see any significant changes unless it provides multiple services and is now treating them as all one service. Construction contractors probably won’t see significant changes on normal contracts, but will need to evaluate how they handle contract modifications to ensure they are following the new standard.
Finally, there is specific guidance in the standard for numerous specific circumstances, including gross vs. net presentation (principal or agent), treatment of incremental costs of obtaining a contract with a
customer, contracts performed over extended periods, software sales and services, licenses and royalty agreements.
Please contact us with specific questions regarding adoption of this standard.