January is here, and that means that the highly anticipated accounting changes to revenue recognition have become effective. This new guidance, formally referred to as Revenue from Contracts with Customers (ASC Topic 606), will have a significant impact on virtually every business in every industry across the United States. As with all major changes to accounting regulations, our aim is to ensure that our clients understand these changes and feel confident and prepared for what’s to come.
In today’s globalized economy, creating harmonized standards has become a necessity for creating a comprehensive framework for addressing all revenue recognition issues across borders and industries. ASC 606 was first issued in 2014 by the Financial Accounting Standards Board (FASB) in consultation with the International Accounting Standards Board (IASB) with the goal of aligning U.S. standards (GAAP) with international accounting standards (IFRS). The guidance went into effect for non-public companies for annual periods beginning December 15, 2018.
ASC 606 is applicable for all contracts with customers, whether it be tangible or intangible goods or services. Contracts excluded from this standard are leases, insurance contracts, financial instruments, guarantees, fixed-odds wagers and contracts falling within the scope of other standards.
In addition to removing inconsistencies and weaknesses from current guidance, the new standard exists to:
- Provide a clear and robust framework for revenue recognition
- Improve comparability of revenue recognition across industries and capital markets
- Reduce the volume of relevant standards with a comprehensive standard to decrease complexity
- Provide expanded disclosure and produce more useful information to the readers of financial statementsThe standard aims to take the current rules that vary by industry and replace them with a principles-based standard across all industries. Ultimately, the standard will require an entity to recognize revenue at the amount that is expected to be received.
Companies will need to exercise significant judgement in applying the guidance and must ensure consistency for all contracts with similar characteristics and circumstances. We also expect that disclosure will be greatly expanded since a certain level of judgment is required.
The Five-Step Process
ASC Topic 606 includes a five-step model for recognizing revenue from contracts with customers.
The first step in applying the new revenue recognition standard is to determine whether a contract exists with a customer.
- Two or more contracts with the same customer should be combined if they were negotiated as a package or if the amount of payment in one contract is dependent on the price or performance of another
- Any modification to a contract should be accounted for as a separate contract if there is an additional promised good or service that is distinct from those included in the original contract and if the price increase reflects the standalone selling price of the additional promise
Identify all performance obligations contained in the contract, meaning all promises to transfer a good or service to a customer.
- Performance obligations are accounted for separately if they are distinct. To be considered distinct the customer must be able to benefit from the good or service on its own with other resources readily available
Next is to determine the transaction price, which is the amount the company expects to be entitled to in exchange for transferring the promised good or service.
- This amount may be fixed, or it may include variable consideration in order to be estimated. Variable consideration should be included in the transaction price only if it is probable of being received
The fourth step is to allocate the transaction price to the various performance obligations previously identified. The allocation should be done on the basis of the standalone selling price of each promised good or service within the contract.
- If the standalone selling prices is not observable, then it must be estimated
- Discounts must all be allocated to the identified performance obligations
The final step is to recognize the revenue when (or as) the company satisfies the promised good or service (performance obligation) to a customer.
- The amount of revenue to be recognized is the amount allocated to the satisfied performance obligation
- A performance obligation is satisfied over time (and therefore recognized over time) if the customer simultaneously receives and consumes the benefits or if the satisfaction of the obligation creates an asset that the customer controls as it is created. If neither of these criteria are met, then the performance obligation should be recognized when the customer obtains control of the good or service
The new revenue standard also provides guidance for costs incurred while obtaining a contract. Incremental costs of obtaining a contract should be capitalized if they are recoverable. This includes only costs that would not have been incurred if that contract had not been obtained. Costs to fulfill a contract should also be capitalized if they are directly related to a contract and are expected to be recovered.
There are two methods allowed for initial implementation, the first being the full retrospective method. Under this method, the company must apply the new standard to each prior period being presented, thus restating prior years as if the new standard had always been in effect.
The second method is the modified retrospective method. Under this method the company must apply the new standard as of the beginning of the period during which the standard is first implemented (for example, as of January 1, 2019). However, this method also requires the company to disclose the amount by which each financial statement line item was affected by the adoption during the year of initial implementation. This requires tracking revenue recognition under both the old guidance and the new guidance in the year of adoption.
There are several practical expedients that are available under each method, all of which must be disclosed and consistently applied.
If using the full retrospective method, practical expedients include:
- The company can elect not to restate contracts that begin and end within the same prior fiscal year
- The company can use hindsight when estimating variable consideration for prior periods
- For all periods presented before the date of initial application, a company need not disclose the amount of the transaction price allocated to remaining performance obligations, nor provide an explanation of when it expects to recognize that amount as revenue
If the modified retrospective method is used, practical expedients include:
- The company may elect to apply the standard only to contracts that are not completed as of the date of initial application
Generally, the assessment of this five-step model should be performed on a contract-to-contract basis. However, a group of contracts may be assessed together if the company reasonably expects that the assessment would not change if each contract had been considered separately.
Judgments and Estimates
The application of the new revenue standard requires a company to make multiple judgments and estimates. Like all judgments and estimates, they should be both reasonable and supportable. Some of the most significant judgments include:
- Whether promised goods and services are distinct
- The estimated outcome of variable pricing
- The estimated standalone selling prices of performance obligations
Since this new revenue standard will impact every industry, we recommend that our business clients identify, inventory, and summarize the company’s types of contracts as soon as possible. Other things to consider include:
- What types of documents are involved in creating a contract with a customer (i.e. signed agreements or invoices)?
- What types of goods or services are typically sold? Be as detailed as possible in this assessment and include items such as warranties and options to renew a contract
- Are goods and services provided within the same contract distinct and capable of being used on their own?
- How is pricing determined and is it consistent across contracts? Do you have price lists or other pricing tools that are used for pricing decisions?
Whether you are well on your way to implementation or in the early phases of preparation, SSF’s experts are here to help you through every stage of the process. If you have questions about the new revenue recognition standard or want to learn more about how your company may be affected, contact us at firstname.lastname@example.org or at 925.271.8700