What to expect for new revenue recognition guidance
The Fourth of July is a day many in the West Michigan business community spent with family and friends at the lake, having cookouts and, hopefully, finding plenty of time to rest and relax. For those who wanted to truly impress family and friends during these low-key events, we hope you took some time to engage in robust dialogue about the new five-step revenue recognition accounting standard also known as Financial Accounting Standards Board Accounting Standards Codification 606 (ASC 606).
Unlike the Declaration of Independence, ASC 606 is unlikely to start a revolution, but it may start an interesting conversation. ASC 606 applies to public and private companies. Private companies must adopt ASC 606 by Jan. 1, which, depending on the company’s revenue streams, could be a long, tedious process. The five-step application model addresses virtually all industries, including those that used to follow industry-specific revenue recognition guidance, including the construction, software and real estate industries.
For many entities, the timing and pattern of revenue recognition will change and this will require careful planning from both a financial statement and income tax perspective. The new standard also introduces an overall disclosure objective together with significantly enhanced disclosure requirements for revenue recognition.
The core principle of ASC 606 is to “recognize revenue to depict the transfer of promised goods/services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods/services.” Overall, the objective of the guidance is to create more comparable revenue policies that faithfully represent how companies should be recognizing revenue.
The guidance provides the following five steps to revenue recognition:
Step 1: Identify the contract
Step 2: Identify separate performance obligations
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations
Step 5: Recognize revenue when/as performance obligations are satisfied
To apply the guidance, companies will need to go through the model in a linear fashion. Beginning with Step 1, the company needs to first identify the contract. The definition of a contract in the guidance is meant to encompass all kinds of agreements that can come from a company’s normal business practices, including long-form signed contracts, purchase orders, emails, etc. The agreement would just need to meet the five criteria outlined in the guidance in order to be a contract. No matter the form of the agreement, if all elements outlined in the guidance are present, the agreement is considered a contract. Additionally, Step 1 provides specific guidance for the treatment of contract modifications and multiple contracts that are entered into at or near the same time.
Step 2 provides guidance to determine the performance obligations in the contract. Step 2 essentially asks, “What am I contracted to do for the customer?” Once the individual deliverables are known, then they would need to be potentially bundled with other deliverables to create a distinct performance obligation. This bundling often requires judgment on the part of the company and typically involves conversations with the sales department, production department and/or service department in order to get a full understanding of how the goods/services relate to each other. A good/service, or bundle of goods/services, is considered to be a performance obligation if it is both capable of being distinct and is distinct within the context of the contract.
In Step 3, the company needs to determine the transaction price for the contract. In many instances, the base transaction price is easily identifiable, but specific consideration needs to be given to the following items:
- Variable consideration: Examples include rebates, discounts, price concessions, etc. This would need to be estimated at contract inception and recorded only to the extent that it is unlikely to be subject to a significant reversal in the future.
- Significant financing components: Transaction prices should be adjusted for the time value of money if the difference in timing of the payments and the timing of when the goods/services are provided is significant.
- Noncash consideration: Specific guidance is given for any forms of consideration received other than cash.
- Consideration payable to the customer: Specific consideration is given to any amounts paid to customers in a transaction.
Step 4 is to allocate that transaction price to the performance obligations. The transaction price should be allocated based on the standalone selling price of each performance obligation, which can be readily determined (e.g., from a list price) or require estimation. There are methods of estimation outlined in the guidance to aid in establishing estimates needed. The transaction price is then allocated based on the relative standalone selling prices determined for each performance obligation. One thing to keep in mind in this step is if any variable consideration or overall discounts in the contract are attributable specifically to one or a few performance obligations, then those amounts should be allocated to those performance obligations. If the variable consideration or contract discounts are not attributable to specific performance obligations, then they should be allocated to the performance obligations based on relative standalone selling prices.
Step 5, the last step, provides guidance on how the revenue for each of the performance obligations should be recognized — whether it should be over time (similar to the current percentage of completion accounting) or at a point in time. The recognition pattern should mirror the transfer of control within the contract. Specifically, revenue should be recognized over time if any of the three criteria outlined in the guidance are met.
For overtime recognition, the company would need to determine a measure of progress that faithfully depicts the transfer of the control of the good/service. The progress measurement can be either an input measure (e.g., direct labor hours) or an output measure (e.g., units produced). If the performance obligation fails to meet any of the criteria outlined in the guidance, then it would be recognized at a point in time. In these instances, revenue is recognized at the point when control transfers to the customer. There have often been changes from current accounting practices as a result of the application of Step 5 guidance as some companies have switched from point in time to overtime recognition, or vice versa. For many companies adopting ASC 606, this change can be significant and require new systems or processes to track the revenue in a new way.
The overall five-step model developed for ASC 606 is extensive and generally comprehensible, but it represents a new way of thinking through revenue recognition for most companies. As such, the time and effort needed to research, analyze and document revenue to fit this new model is likely to be significant. Moreover, the expanded disclosures will be new for all companies regardless of whether there is a large monetary impact of adoption.
Given the magnitude of implementation, this new revenue recognition guidance will vary from company to company; the more proactive companies will start their implementation process immediately. The implementation process likely will include establishing an implementation timeline, identifying the applicable revenue streams and walking those revenue streams through the five-step model via a formal technical analysis. In practice, even if the timing and pattern of revenue recognition do not change, it is possible new and/or modified processes and internal controls will be needed in order to comply with the expanded financial statement disclosure requirements.
Kevin Patterson is an audit partner and Alison O’Brien is an advisory senior with the local office of accounting firm BDO USA LLP. The views expressed above are the authors’ and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.