Industry revenue recognition simplified

After several years, multiple drafts and numerous letters from interested parties, the Financial Accounting Standards Board and the International Accounting Standards Board have issued guidance on when and how to recognize contract revenue.

The decision to revise the generally accepted accounting principles (GAAP) for this area of accounting was reached after the Financial Accounting Standards Board (FASB) realized reporting standards had become increasingly complex.

Different industries reporting the same types of transactions were using diverse methods. With the needs of financial statement users in mind, the new guidance aims to simplify preparation of statements as well as improve comparability across entities, industries, jurisdictions and capital markets. Inconsistencies and weaknesses were addressed and disclosure requirements strengthened.

The new guidance has the following core principle as its foundation: “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 or services.”

The new standard describes the steps companies must apply consistently.

1) Identify the contract with the customer – A contract is defined as an agreement between two parties. Necessary components include approval and commitment of the parties and identification of rights and payment terms. The contract must have commercial substance, and there must be the likelihood that the company will collect from the customer. In some cases, multiple contracts with one customer can be combined for reporting purposes.

2) Identify the performance obligations in the contract – Performance obligations are distinct promises to transfer goods or services to the customer. Distinction is defined by the ability of the customer to benefit from the good or service on its own. The seller’s promise to transfer the good or service is also separately identifiable.

3) Determine the transaction price – The transaction price is the amount the seller expects to receive upon transfer of the good or service, including the amount collected on behalf of third parties. The price may be fixed, but it can also be variable or include consideration other than cash.

4) Allocate the transaction price to the performance obligations in the contract – This is a key piece of the provision, requiring the expected revenue to be allocated on the “basis of the relative standalone selling price.” Discounts or variable consideration should be allocated to one or more obligations (as appropriate), not across the board. The new variable consideration model treats bonuses, discounts, returns and right of return consistently.

5) Recognize revenue when the reporting organization satisfies a performance obligation – Satisfaction is defined as when the good or service is delivered to the customer or the customer takes control of it. The transfer may relate to a point in time (physical goods) or over time (services received).

Expensing of incremental contract costs is also permitted if the amortization period is under one year and the costs would not have been incurred if the contract had not been obtained.

The new guidance also has provisions for disclosure requirements regarding the “nature, amount, timing and uncertainty of revenue and cash flows” arising from customer contracts. Disclosures must include reporting the break-out of revenue by category; contract balances including assets, receivables and liabilities; and performance obligations and judgments.

Any public organization that enters into contracts with customers will be obligated to comply with the new ruling, which goes into effect Dec. 31, 2016. Nonpublic businesses and organizations get an additional year and must report for periods after Dec. 31, 2017.

The new accounting standards have implications for manufacturing companies, especially those that bundle products with service contracts. Some of the initial revenue will be reported later, as services are delivered.

Allocating revenues to the various components may pose a significant challenge, requiring the overhaul of present accounting systems. The impact of variable consideration – discounts, incentives, returns – on revenues is also another complex area.

Businesses are urged to work closely with their CPAs to review and prepare to adjust accounting systems well before the deadline.