The bodies that establish US and international accounting standards have released new guidance on the timing of companies’ revenue recognition. The new guidance from the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) has been in development for more than a decade and is intended to enhance comparability of revenue recognition practices across companies, industries, jurisdictions, and capital markets. It applies to both public and private companies.
FASB’s version of the guidance, which will significantly change US Generally Accepted Accounting Principles (GAAP), was published in Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. Existing GAAP contains numerous standards regarding the recognition of revenue from customer contracts, including a variety of specialized standards applicable only to certain industries or transactions. The ASU adopts a single process for all companies and transactions. Some companies will end up with different timing for revenue recognition — reporting revenue on financial statements earlier or later — which could affect investors’ perceptions of their performance. Companies will also need to make more sweeping disclosures related to their contracts with customers.
Background of the new converged standards
GAAP and International Financial Reporting Standards (IFRS) have applied divergent rules for revenue recognition, but both sets have been the subject of criticism. As FASB noted in its guidance, GAAP has comprised broad, general recognition concepts together with numerous recognition requirements for particular industries (for example, software and construction) or transactions (for example, multiple-element arrangements). This mishmash of rules sometimes led to different accounting for economically similar transactions. IFRS, on the other hand, provided only limited guidance and required inadequate detail. Moreover, it reflected different fundamental principles.
Both the new GAAP guidance and the new corresponding IFRS rule are founded on a core principle — that companies should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration (payment) that it expects to be entitled to in exchange for the goods or services.
5-step recognition framework
To accomplish that core principle, the new guidance specifies five steps a company must follow to determine when and how to properly recognize revenue on its financial statements:
- Identify the contract with a customer.
The ASU applies to each contract a company has with a customer, as long as the contract satisfies certain criteria. In some circumstances, the company will need to combine contracts and account for them as a single contract. (The guidance also contains rules for contract modifications.)
- Identify the company’s performance obligations (or promises) under the contract.
If a contract obligates the company to transfer more than one good or service to a customer, the company may account for each performance obligation only if the good or service is distinct or a series of distinct goods or services that are substantially the same.
A good or service qualifies as “distinct” if
a) the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer, and
b) the company’s promise to transfer the good or service is separately identifiable from other promises in the contract.
- Determine the transaction price.
The company must determine the price it expects to be entitled to in exchange for transferring promised goods or services to a customer. The guidance lists multiple factors the company should consider, including the effects of any variable payment or significant financing components.
- Allocate the transaction price to the performance obligations in the contract.
The company will usually allocate the transaction price to each performance obligation according to the relative “standalone selling price” of each distinct good or service promised in the contract. It should also allocate any discounts or variable payments that relate entirely to one of the performance obligations to that obligation.
- Recognize revenue when (or as) performance obligations are satisfied.
The company must recognize revenue when it satisfies a performance obligation by transferring the promised good or service to a customer — when, in other words, the customer obtains control of the good or service. The amount recognized is the amount allocated to the performance obligation in the previous step.
Note that, when a performance obligation is satisfied over time, rather than at a single point in time, the company must recognize revenue over time, by consistently applying a method of measuring progress toward complete satisfaction of the obligation.
Heightened disclosure requirements
Under existing GAAP, the required disclosures about revenue are limited and lack cohesion. The current rules require only descriptions of a company’s revenue-related accounting policies and the policies’ effects on revenue, including rights of return, the company’s role as a principal or agent, and customer payments and incentives. Investors and other users of financial statements reported that they found that the disclosure requirements in both GAAP and IFRS were insufficient.
The new guidance substantially expands disclosure requirements. It requires a cohesive set of qualitative and quantitative disclosures designed to provide users of financial statements with useful information about the company’s contracts with customers. Required disclosures will include information about the nature, amount, timing, and uncertainty of revenue that is recognized.
Likely effects on certain industries
Many companies are expected to record revenues earlier under the new guidance, which requires companies to account for the effects of variable consideration, such as sales incentives, discounts, and warranties. The guidance is expected to have an especially dramatic effect on certain industries, though, including those that routinely sell goods or services in bundled packages or enter into contracts that include variable payment terms (for example, performance bonuses or rights of return).
Wireless providers (which frequently sell a customer a device at the same time as a service plan) and software companies (which sell licenses to software along with future upgrades or other vendor obligations), for example, could see accelerated recognition of revenue. As of now, these companies customarily recognize revenue only to the extent they have actually received cash.
Software companies might be affected by rules addressing recognition of royalties from licenses. The ASU eliminates the distinction between term licenses and perpetual licenses and instead focuses on the performance obligations under a license.
The licensing rules may affect media companies that collect sales- or usage-based royalties on intellectual property, too. The guidance permits recognition of such revenue only when the underlying sale or usage occurs.
The new rules apply only to revenues from customer contracts related to the transfer of nonfinancial assets. Contracts that continue to be covered by other FASB rules include insurance contracts, leases, financial instruments, guarantees, and nonmonetary exchanges between entities in the same line of business to facilitate sales.
Treatment of costs related to obtaining or fulfilling customer contracts
The guidance includes rules for accounting for some costs related to obtaining or fulfilling a contract with a customer — clarifying whether to capitalize or expense them. Incremental costs of obtaining a contract (those that wouldn’t otherwise be incurred, such as sales commissions) are recognized as an asset.
For fulfillment costs, the company should apply any other applicable standards (such as those for software or property, plant and equipment). If none apply, the company recognizes an asset from the costs if they meet certain criteria.
Effective dates for public and nonpublic companies
The new ASU is effective for public companies for annual reporting periods (including interim reporting periods within) beginning after Dec. 15, 2016. Early implementation is not permitted for public companies.
For nonpublic companies, compliance is required for annual reporting periods beginning after Dec. 15, 2017, and interim and annual reporting periods after those periods. A nonpublic entity can elect early adoption, but no earlier than the effective date for public entities.
Making the transition
FASB and the IASB will soon form a joint transition resource group consisting of 15–20 specialists representing preparers, auditors, regulators, financial statement users and other stakeholders, along with members of the two organizations. The group will consider stakeholder concerns and alert FASB and the IASB to potential implementation issues before the guidance takes effect.
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