Articles

Is your Business Ready for the New Model of Revenue Recognition? by Christopher Cichoski, CPA


Posted on November 09, 2015 by Christopher Cichoski

 

In May 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) issued new revenue recognition guidance that will affect substantially all businesses, including those in the real estate, construction, software, telecommunication, manufacturing and distribution industries, as well as certain not-for-profit entities. Privately held companies must implement the guidance for annual reporting periods beginning after December 15, 2018, but they may adopt the new requirements as early as 2017.

 

While 2018 may seem like a far-off date, businesses would be well-served to begin assessing their current contract procedures now and establishing new systems and policies to ease the transition to the new revenue recognition standard in the not-so-distant future.

 

Why is there a New Standard for Recognizing Revenue?

The new guidance moves away from the traditional industry- and transaction-specific financial reporting requirements under U.S. Generally Accepted Accounting Principles (GAAP.) The new standard is more principles-based and requires enhanced financial statement disclosures, which are intended to facilitate the comparability of financial results of business operations across all industries and capital markets.

 

What is included in the New Provisions?

Under the new standards, all businesses will be required to recognize revenue from contracts with customers using the same five-step model. However, based on the results of applying this new model, different businesses will account for revenue either at a particular point in time or over time using a percentage-of-completion method of performance measurement.

 

Step One: Identify the Contract

Under the new standard, a contract is defined as an agreement between two or more parties that creates specific, enforceable rights, as a matter of law. Furthermore, a contract will exist when the agreement has commercial substance, when it identifies rights to goods and services and related payment terms, when entitled collection is “probable,” and when the parties approve the agreement and commit to their contractual obligations. An important point to consider is that subsequent modifications to a contract could result in the creation of a new contract, an addition to the existing contract, or both.

Step 2: Identify the Contract Performance Obligations

Performance obligations are contractual promises to deliver goods or services to a customer. A performance obligation may be distinct, or it may be combined with other goods or services. Identifying if goods and services are “distinct” requires they meet the following criteria:

  1. The customer can benefit from the good or service, on its own or together with other resources that are readily available to it, and
  2. The promise to transfer the good or service is separately identifiable from other promises in the contract.

The new model of revenue recognition offers additional guidance to help businesses determine when goods and services are not distinct. More specifically, promised goods or services may be bundled or unbundled more frequently under the new guidance. As a result, businesses must carefully analyze the various goods and services they sell and how they relate to each other in meeting the contract terms.

 

Step 3: Determine the Transaction Price

Transaction prices, or the amounts that businesses expect as payment in return for transferring goods or services to a customer, must include an assessment of the following components:

  1. Variable consideration and constraining estimates (including discounts, credits, price concessions, returns, or performance bonuses and penalties)
  2. Consideration payable to the customer
  3. The existence of a significant financing component
  4. Noncash consideration

These factors will weigh on the ultimate transaction price a business will estimate it will be entitled to receive and how and when it will recognize the resulting revenue on its financial statements.

 

Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract

To allocate an appropriate transaction price to each performance obligation, a business must first determine at contract inception the stand-alone selling price of each distinct product and service it promises to deliver. These amounts may not be easily recognizable due to volume discounts or bundling. In these instances, businesses will need to develop new processes and procedures for estimating stand-alone selling prices of the goods and services to be delivered.

 

Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation

Businesses will recognize revenue either at a point in time or over the period in which it satisfies a performance obligation. Transfers that occur over time include those in which:

In these situations, the business will recognize revenue over time using performance measurements that may include its output (i.e. units produced) or its input (i.e. hours of labor or costs incurred). Applying these methods of measurement for satisfaction of an obligation that occurs over time further requires a business to identify the moment at which it transfers control, which may include the time at which the customer accepts the asset and takes significant risks and rewards of ownership or takes physical possession or legal title to it. Additionally, the point of time may occur when the business has a present right to payment for the asset. Special rules will apply when performance obligations involve the licensing of intellectual property.

 

In addition to this five-step model of revenue recognition, businesses should begin preparations to comply with enhanced disclosure requirements about customer contracts under the new standard. Businesses should begin to take the time to identify data gaps between existing practices and those required in the future, and making significant changes, as needed, to existing policies, processes and IT systems.

 

The advisors and accountants with Berkowitz Pollack Brant work with businesses across all industries to develop and implement strategies that meet ever-changing, often complex, financial-reporting and disclosure requirements.

 

About the Author: Christopher Cichoski, CPA, is a senior manager of Audit and Attest Services with Berkowitz Pollack Brant, where he provides business consulting services and conducts reviews, compilations and audits for clients in the real estate and construction sectors. He can be reached in the Miami CPA firm’s office at (305) 379-7000 or via email at ccichoski@bpbcpa.com.