In 2014, the Financial Accounting Standards Board (“FASB”) and International Accounting Standards Board (“IASB”) issued comprehensive revenue recognition standards entitled “Revenue from Contracts with Customers”. It takes effect in 2018 for public companies and in 2019 for all other companies, and addresses virtually all industries in U.S. GAAP, including those that previously followed industry-specific guidance such as the real estate, construction and software industries. For many entities, the timing and pattern of revenue recognition will change. In some areas, the changes will be very significant and will require careful planning.
The new standard also introduces an overall disclosure objective together with significantly enhanced disclosure requirements for revenue recognition. In practice, even if the timing and pattern of revenue recognition does not change, it is possible that new and/or modified processes will be needed in order to comply with the expanded disclosure requirements.
OVERVIEW OF THE STANDARD
The standard’s core principle is to recognize revenue from contracts with customers upon the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To accomplish this objective, the Standard requires five basic steps: (1) identify the contract with the customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when (or as) the entity satisfies a performance obligation.
The first step is to identify the contract(s) with the customer. Whatever the form, a contract creates enforceable rights and obligations between a vendor and its customer.
After identifying the contract(s) with the customer, a vendor separates the contract into what are termed ‘performance obligations’. A performance obligation is a promise by a vendor to transfer goods or services to a customer. Each performance obligation is ‘distinct’, being either a good or service from which the customer can benefit on its own (or in combination with other readily available goods and services); or two or more goods and services (such as the supply of construction material and labor) that are combined if, in reality, they represent one overall performance obligation.
In the third and fourth steps, a vendor determines the transaction price of the entire contract and then allocates the transaction price among the different performance obligations that have been identified.
In the fifth step, a vendor assesses when it satisfies each performance obligation (which may be at a point in time, or over time) and recognizes revenue. The principle is based on the point at which the customer obtains control of the good or service.
The Standard provides guidance and many examples for applying these five steps. For example, the Standard explains that a performance obligation is satisfied when control is transferred to a customer for a good or service. Each performance obligation is satisfied either at a specific point in time or over time. Revenue is recognized when control is transferred if the performance obligation is satisfied at a point in time. However, if the performance obligation is satisfied over time, then the entity must recognize revenue over time using a measure of progress based either on “input” or “output.”
Certain industries anticipate challenges in the practical application of the standard including software development, telecommunication and mobile phone service providers, real estate construction companies, franchisors, and retail companies.
The standard provides an option for full or modified retrospective adoption in the financial statements. The standard does not apply to lease contracts, insurance contracts, guarantees, financial instruments, and certain non-monetary exchanges.
The standard will affect the timing and measurement of revenue recognized for book purposes. Changes in the timing of revenue recognition under the standard will have implications for taxable income, possibly resulting in required accounting method changes, new book/tax differences, and adjustments to deferred tax accounting.
While this seems like a ways off, this standard is significant and will impact many entities in some way. Transition to this standard not only impacts accounting and disclosure policies, it potentially impacts systems and processes, as well as structuring of contracts, etc.
Over the next few weeks, HBE will provide additional newsletter articles featuring industry specific guidance.
Content from this article originally appeared in BDO USA, LLP’s “BDO Knows: Revenue Recognition” newsletter (October 2014). Copyright © 2014 BDO USA, LLP. All rights reserved. www.bdo.com