June 18, 2014
In September of 2002, the Financial Accounting Standards Board [FASB] and the International Accounting Standards Board [IASB] formally added a joint project to their agendas to attempt to converge revenue recognition. During the course of the next 12 years, the Boards worked to produce a solution issuing a preliminary views document in 2008 and three exposure drafts in 2010, 2011, and 2012. On May 28, 2014, the Boards issued a final, substantially converged revenue recognition standard.
The revenue recognition standard, Accounting Standards Update [ASU] 2014-09, Revenue from Contracts with Customers, will substantially replace the numerous industry based accounting and audit guides, which have been codified in the FASB Accounting Standard Codification [ASC] 605, Revenue Recognition, with FASB ASC 606, Revenue from Contracts with Customers. The standard is effective for public entities for annual reporting periods beginning after December 15, 2016, including interim periods therein. The standard is effective for nonpublic entities for annual reporting periods beginning after December 15, 2017. The FASB did not permit early adoption. However, a nonpublic company may elect to apply the guidance early so long as it is after the effective date for public companies. The IASB did permit early adoption.
Practice Note: While the effective date may seem to be far off, some constituents are expressing concern about the effective date being too soon. These constituents include SEC registrants who desire to retrospectively present revenue for prior periods at the effective date. Accordingly, they will need to present 2015, 2016, and 2017 under the new revenue recognition rules. Therefore, any necessary system, technology, and internal control processes would need to be completed by the end of 2014. The FASB may consider a deferral of the effective date. However, there are no immediate plans to extend the effective date based on a recent FASB webcast held in June.
The core principle, cited in the standard, is that an entity should recognize revenue to depict the transfer of promised 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 and services.
The application of the core principle is broken down into five steps. These five steps are:
- Identify the contract[s] with a 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
In this report we will broadly discuss the application of the core principle and general practice implementation matters. In future reports, we will discuss in more detail application of the core principle, address practice implementation matters, and focus on industry-specific issues with the new revenue recognition standard. We will also provide illustrations and examples when appropriate.
Practice Note: The new revenue recognition standard is a “principles based” standard. It will be important to monitor implementation interpretations and trends through the period leading up to the effective date. Implementation guidance will be coming from many sources including early adopters under International Financial Reporting Standards [IFRS] and also the implementation group [known as the “Joint Transition Resource Group”] that the Boards intend to form. The outreach of the Boards during the transition period may warrant further standards-setting activity.
Step 1: Identify the Contract[s] with a Customer
The standard references the term “contract” frequently. In the U.S., we typically think of a contract as a written, legal document. The standard indicates that contracts can be written, oral, or implied by an entity’s customary business practices. While a contract can be more than a written, legal document, it must be enforceable as a matter of law. The concept of enforceability will create a new, legal element to practice.
The contract must also meet certain criteria, including a determination that it is probable that the entity will collect the consideration in the contract, in order to qualify as a contract for which revenue is recognized. These criteria, in effect, will create a U.S. generally accepted accounting principles [U.S. GAAP] definition of a contract. Contracts should be combined if they have been negotiated as a package or have linked consideration, or are goods and services from one performance obligation. Contract modifications are accounted for as a separate contract if the additional goods or services are distinct from the original contract and the price for the additional goods or services are consistent with the standalone selling price for the additional goods or services. Contract modifications that do not meet these criteria should be accounted for as an adjustment to the original contract on a cumulative catch-up basis or as if it were a termination of the existing contract and the creation of a new contract if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification.
Practice Note: Contract modifications need to be approved by the parties to a contract. The modification can be approved in writing or by oral agreement or implied by customary business practices. This may result in a change in accounting practice for certain unapproved change orders and claims.
Throughout the standard, the term “contract” asset or liability is used. Contract assets are used when an entity performs by transferring goods or services before the customer pays the consideration or as an account receivable, depending on the nature of the entity’s right to consideration for its performance. If an entity has billed its customer for goods or services for which it has satisfied its performance obligations, this amount should be shown as an account receivable. If an entity has an asset under the standard prior to having the right to consideration, the asset is known as a contract asset. Contract liabilities can exist if a customer pays consideration or an amount of consideration is due before an entity performs by transferring a good or service. The standard does allow alternatives to the terms contract asset and contract liability. This may allow terms like “billings in excess of costs on uncompleted contract” seen in typical construction financial statements to continue to be used. However, if an entity uses an alternative term, the entity should provide sufficient information for a user of the financial statements to distinguish between unconditional rights to consideration [receivables] and conditional rights to consideration [contract assets]. Further, it will be important to monitor trends in usage of terms as the standard is implemented as using old terms may cause users to question if an entity has completely and accurately applied the new standard.
Step 2: Identifying Performance Obligations in the Contract
A good or service that is distinct is accounted for separately and are also a separate unit of account. A good or service is distinct if:
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
The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract
The standard further details these two criteria. It cites a number of examples and indicators of when a good or service is “separately identifiable” from other promises in the contract. The concept of a “distinct” good and service will be one of the most important principles-based judgments in implementing the revenue recognition standard.
Practice Note: The determination of what is “separately identifiable” could be challenging. While the standard has numerous indicators and examples, the degree of judgment needed to apply this guidance is significant. This is one example of areas where the CPEA staff feels that industry trends and conventions will develop over time.
The standard also notes that promises may not be limited to a good or service that is explicitly promised in the contract. A contract with a customer may include promises that are implied by an entity’s customary business practices, published policies, or specific statements if those promises create a valid expectation of the customer that the entity will transfer a good or service to the customer at the time of entering the contract. Some entities have viewed these implied performance obligations as marketing costs that have been accounted for on a cash basis. For these entities, this will be a change in practice.
Step 3: Determine the Transaction Price
The entity shall consider the terms of the contract and its customary business practices to determine the transaction prices. Specific guidance is included in the standard for variable consideration, refund liabilities, financing components, noncash consideration, and consideration payable to a customer.
Practice Note: The guidance for variable consideration and consideration payable to a customer may differ from current practice for many entities. Consistent with current U.S. GAAP, many entities will not recognize variable consideration until the performance condition has been completely satisfied. However, under the standard, variable consideration should be estimated and recognized throughout the life of the contract subject to an overall constraint. The overall constraint is that estimates of variable consideration only should be included in the transaction price to the extent it is probable that a significant reversal in the amounts of cumulative revenue recognized will not occur when the uncertainty is resolved. Variable consideration includes incentive clauses and performance bonuses, but also can include penalty and clawback provisions. Consideration payable to a customer is accounted for as a reduction of the transaction price unless for a distinct good or service that the customer transfers to an entity.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
The standard requires that an entity allocate the transaction price to each performance obligation [or distinct good or service] in an amount that depicts the amount of consideration to which the entity expect to be entitled in exchange for transferring the promised good or service to the customer. If multiple performance obligations exist in a contract which are broken out as distinct [see Step 2] units of account, then consideration is allocated to each unit of account based on relative standalone selling prices. An exception is made for variable consideration and discounts within one contract which can be allocated to specific units of account based on certain criteria.
Step 5: Recognize Revenue when [or as] the Entity Satisfies a Performance Obligation
When performance obligations are satisfied at a point in time, revenue is recognized when the customer obtains control of the promised asset and the entity satisfies a performance obligation. Control is measured in these situations by indicators which include, but are not limited to, present right to payment, legal title, physical possession, risks and rewards of ownership, and customer acceptance.
If performance obligations are satisfied over time, revenue can be recognized as the performance obligation[s] are satisfied over the life of the contract. However, an entity must meet one of three criteria in order to qualify for recognition of revenue over the life of the contract.
Customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. An important question to ask related to this criteria is whether another entity would need to substantially re-perform the work the entity has completed to date if that other entity were to fulfill the remaining obligation to the customer.
Entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced [for example, a home remodel].
Entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
An entity that is not able to satisfy one of the three criteria for recognition of revenue over the life of the contract defaults into recognizing revenue at a point in time [see above] when the customer obtains control of the promised good.
Practice Note: Many long-term contracts in the manufacturing and construction industry that currently use percentage of completion revenue recognition under FASB ASC 605-35 would appear likely to satisfy at least one of the criteria for recognition of revenue over the life of the contract. However, practitioners and their clients will need to examine contracts in detail to assess the criteria since application of the standard may not always seem as easy as the first impression. For example, the standard cites examples where payment schedules in a contract are insufficient to provide an entity with an enforceable right for payment for performance completed to date. Also, certain speculative building or manufacturing projects may not qualify for recognition of revenue over the life of the contract.
When an entity recognizes revenue over the life of the contract, an entity shall recognize revenue on that contract by measuring progress toward complete satisfaction of the performance obligation. The standard indicates two acceptable methods for measuring progress toward complete satisfaction of the performance obligation. These two methods are as follows:
The input method
The output method
Input methods generally are costs that an entity incurs in the process of satisfaction of performance obligations. Examples of input methods would be recognition of revenue based on labor hours, costs incurred, machine hours, and passage of time. Output methods are based on direct measurements of value to the customer and include methods such as surveys of performance completed to date, appraisals of results achieved, milestones reached, and units produced or units delivered.
The standard does not express an explicit preference for input methods or output methods. However, the standard does indicate that the objective when measuring progress is to depict the entity’s performance in transferring control of a good or service to the customer and that the entity shall consider the nature of the good or service that the entity promised to transfer to the customer. Further, when using the input method, the standard does not permit certain costs to be considered when measuring progress toward complete satisfaction of a performance obligation. These are costs which do not depict the entity’s performance in transferring control of a good or service to the customer. The standard indicates that examples of these types of costs are the costs of unexpected amounts of wasted materials, labor, or other resources which were incurred to attempt to fulfill the performance obligation. An example in the standard also provides an instance under an input method where an entity would not recognize revenue on uninstalled materials since the cost incurred would not accurately measure progress toward completion of the entity’s performance obligation.
Practice Note: Practice implementation of the methods for application of recognition of revenue over the life of a contract will be important for impacted industries [examples are construction, defense, software, and certain manufacturers] to monitor. Industry, auditor, and user preferences for certain input or output methods may develop which may differ from current practice today. Further, the identification and exclusion of certain costs from the input methods [see discussion above] may be a challenge as a contract progresses since it is not always readily apparent what is unexpected waste or uninstalled material.
Each of the five steps above may not be needed for every transaction. For example, a contract may have only one performance obligation, so there is no need to identify more than one obligation or to perform an allocation of the purchase price.
The standard also applies to certain costs in addition to revenue. It is important to note that the requirements on contract costs do not apply if the costs incurred in fulfilling a contract with a customer are in the scope of another Topic in the FASB ASC. Examples include FASB ASC 330, Inventory, FASB ASC 360, Property, Plant, and Equipment, and FASB ASC 985, Software. Contract costs guidance is codified in FASB ASC 340, Other Assets and Deferred Costs.
Costs to fulfill a contract are capitalized if costs meet all of the following criteria:
The costs relate directly to a contract [or a specific anticipated contract]
The costs generate or enhance resources of the entity that will be used in satisfying [or in continuing to satisfy] performance obligations in the future
The costs are expected to be recovered
The standard provides examples of costs that directly relate to a contract including direct labor, direct materials, allocations of costs that related directly to the contract or to contract activities, costs that are explicitly chargeable to the customer under the contract, and other costs that are incurred only because the entity entered into the contract [for example, payments to subcontractors].
Costs indicated by the standard should be expensed as incurred. Those costs include general and administrative expenses [unless those costs are explicitly chargeable to the customer under the contract], costs of wasted materials, labor, or other resources to fulfill the contract that were not reflected in the price of the contract, costs that relate to past performance on performance obligations, and costs that relate to unsatisfied performance obligations that the entity cannot distinguish from costs that relate to satisfied performance obligations.
Practice Note: The new standards on contract costs are a potentially significant area of change from current practice. Indirect costs, such as those related to overhead, would no longer be capitalized contract costs for entities applying the new standard for contract costs. Costs of wasted materials, labor, or other resources that were not reflected in the price of the contract also would not be capitalized for entities applying the new standard for contract costs. However, certain entities, such as manufacturers, would continue to be able to capitalize indirect costs under FASB ASC 330. As discussed above, the contract cost guidance does not apply to entities who are capitalizing costs under another Topic in the FASB ASC. The end result will be different answers for certain costs depending on the industry in which the entity operates.
Incremental costs of obtaining a contract are capitalized if the entity expects to recover those costs. Incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that would not have been incurred if the contract had not been obtained. An example of these costs is sales commissions.
Practice Note: The standard cites sales commissions as an example of incremental costs of obtaining a contract that are recognized as an asset. Many entities previously may not have capitalized these costs and this would be another area of change in practice. Entities that are under current long-term contract guidance will need to evaluate whether other pre-acceptance costs in the bidding or proposal stage will be able to continue to be capitalized.
Contract costs should be amortized on a systematic basis consistent with the transfer of the goods or services to which the asset relates. An entity should recognize an impairment loss if the carrying amount of the asset exceeds the remaining amount of consideration that the entity expects to receive less the costs that relate directly to providing the goods and services and that have not been recognized as expenses. As a practical expedient, an entity may expense these costs when incurred if the amortization period is one year or less.
The disclosure requirements in the standard are extensive, spanning five pages in the standards, and will represent a significant expansion of current disclosures for revenue recognition and accounts receivable. Certain private companies are exempt from some of the disclosure requirements and may elect to make qualitative disclosures instead of quantitative disclosures in some instances.
The disclosure requirements, disclosure exemptions, and disclosure elections are detailed in this section, and are separated by category of disclosure. Throughout the requirements noted below, *** denotes entities other than a public business entity, a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market, or an employee benefit plan that files or furnishes financial statements with or to the SEC, that may elect not to provide any or all of this disclosure.
Contracts with customers
Revenue recognized from contracts with customers separate for other sources of revenue
Any impairment losses recognized on any receivables or contract assets arising from an entity’s contracts with customers [separate from impairment losses from other contracts]
Disaggregation of revenue
Disaggregate revenue into categories that depict how revenue and cash flows are affected by economic factors. Qualitative disclosure is permitted for entities described above.
Explain the relationship with segment disclosures [if segment reporting is applicable]
Information about contract balances
Opening and closing balances
Amount of revenue recognized from contract liabilities ***
Revenue recognized in the reporting period from performance obligations satisfied [or partially satisfied] in previous periods ***
Timing of satisfaction of its performance obligations and how it relates to the typical timing of payment as well as the effect those factors have on the contract asset and contract liability balances ***
Explanation of significant changes in contract balances ***
When the entity typically satisfied performance obligations
The significant payment terms
The nature of the goods or services that the entity has promised to transfer
Obligations for returns, refunds, and other similar obligations
Types of warranties and related obligations
Remaining performance obligations. This would apply if the contract’s original duration is greater than one year or if using input methods to recognize revenue over the life of the contract.
Significant judgments in the application of the guidance
Performance obligations that an entity satisfies over time
Performance obligations satisfied at a point in time
Determining the transaction price and the amounts allocated to performance obligations ***. An entity shall disclose information about the methods, inputs, and assumptions used for all of the following:
Determining the transaction price ***
Assessing whether an estimate of variable consideration is constrained *** [further guidance on whether an estimate is constrained are included in paragraphs 11-13 of FASB ASC 606-10-32]
Allocating the transaction price, including estimating standalone selling prices of promised goods or services *** and allocating discounts *** and variable consideration to a specific part of the contract [if applicable]
Measuring obligations for returns, refunds, and other similar obligations ***
The Boards used language in the standard to attempt to require relevant disclosures to be highlighted and provide disclosures consistent with certain of the intentions of the disclosure framework project indicating that,
An entity shall consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the various requirements. An entity shall aggregate or disaggregate disclosures so that useful information is not obscured by either the inclusion of a large amount of insignificant detail or the aggregation of items that have substantially different characteristics.
The contrast of the extensive disclosure requirements and the requirement above to highlight relevant disclosures adds a new element to the financial reporting process in the U.S. Past practice in making disclosures has been rooted in compliance with less [or no] consideration placed on emphasis or potential ambiguousness of disclosures. It will be interesting to see how these concepts are applied in practice as the standard is implemented.
The standard permits retrospective presentation to all periods presented or by recognizing a cumulative effect of initially applying the guidance to the opening balance of retained earnings at the date of initial application [“cumulative effect transition”]. If cumulative effect transition is adopted, an entity shall disclose the amount by which each financial statement line item is affected in the current period as a result of applying the standards and an explanation of the significant change between the reported results under the standard and the revenue guidance in effect before the change.
Practice Note: For many entities, the apparent simplicity of the cumulative effect transition would appear to be the default choice. However, differences in revenue recognition between the new and old standards may result in some revenue disappearing on transition. For example, if an entity had variable consideration or deferred revenue it had not recognized at the date of adoption but would have recognized under the new standard at the date of adoption, this revenue would vanish through the cumulative effect adjustment to retained earnings at the date of adoption. There will also be circumstances in which revenue is recorded twice as a result of the transition and difference between the standard and current U.S. GAAP.
Implementation guidance is included in the standard on applying the concepts to a variety of specific situations in addition to provide examples on the concepts discussed in this report. These include:
Right of return
Customer options for additional goods or services
Customer loyalty programs and breakage
Customer acceptance clauses
Principal versus agent
Bill and hold arrangements
Nonrefundable upfront fees
Practice Note: The Basis for Conclusions in Section C of the final ASU may also be helpful. By design, the FASB did not provide any industry-specific guidance.
The revenue recognition standard is the result of a 12 year process between the FASB and IASB. It unifies under one set of standards previously existing industry accounting and audit guides which often had conflicting rules based on industry and numerous interpretations which made it difficult for practitioners to master. The standard also represents a major test case for principles-based accounting standards in the U.S. Practitioners should be aware that detailed rules covering all specific situations are not likely to be forthcoming. As a result, monitoring implementation trends and guidance will be more important than previous accounting standards.
Practitioners should also be cognizant of the impact of revenue recognition changes on the tax reporting process. Deferrals and/or accelerations of revenue based on the new standard are not necessarily acceptable by the IRS for tax reporting purposes. Many changes to revenue recognition methods that are acceptable to the IRS might also require consent to change accounting methods. Tax implications also can extend beyond income taxes. Revenue recognition changes and changes in allocations to performance obligations could impact sales taxes as well.
Revenue is the starting point for the income statement but also forms the foundation for trend analysis by many users and management. Revenue, as defined by U.S. GAAP, also is used in many purchase agreements, earnouts, buyouts, incentive pay arrangements, phantom stock agreements, stock compensation arrangements, debt covenants, and customer agreements. The requirements in the standard for contract costs could have an impact on “cost plus” type contracts common in construction, defense, and health care industries. Clearly, the impact of changes in revenue recognition ripples beyond the income statement. For heavily impacted industries, implementation strategies which commence in the year of adoption are likely to be unsuccessful and potentially costly.
The CPEA will be covering the new revenue recognition standard extensively in the coming years through its effective date. We see industry impact being uneven across the economy. Certain industries such as technology, telecommunications, real estate, construction, asset management and retail will be heavily impacted. Industries which feature little post-transaction involvement between the customer and the vendor may have little impact for recognition and measurement matters. However, all industries will be impacted by the extensive disclosure requirements. Future CPEA reports will cover industry impacts in detail as well as in depth analysis of each step in applying the standard. We will also monitor and report on implementation trends and issues as they arise and report them.
The CPEA provides non-authoritative guidance on accounting, auditing, attestation, compliance and SSARS standards. Offical AICPA positions are determined through certain specific committee procedures, due process adn extensive deliberation. The views expressed by CPEA staff in this report are expressed for the purposes of providing member services and other purposes, but not for the purposes of providing accounting services or practicing public accounting. The CPEA makes no warranties or repreenations concerning the accuracy of any reports issued.
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