Revenue is one of the most important measures used by investors in assessing a company’s performance and prospects. However, revenue recognition accounting guidance differs between U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) — and many believed both standards were in need of improvement.
On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued converged guidance on recognizing revenue from contracts with customers. The new guidance is a major achievement in the boards’ joint efforts to improve this important area of financial reporting.
Presently, U.S. GAAP has complex, detailed and disparate revenue recognition requirements for specific transactions and industries including, for example, software and real estate. As a result, different industries use different accounting for economically similar transactions.
The objective of the new guidance is to establish the principles to report useful information to users of financial statements about the nature, timing and uncertainty of revenue from contracts with customers.
The new guidance:
To meet these objectives, the new guidance establishes the following core principle:
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.
There are numerous requirements for recognizing revenue
Other than disclosures in accounting policies and segment reporting, most companies and reporting organizations provide limited information about revenue contracts
Many goods or services promised in a contract are deemed not to be distinct revenue-generating transactions when in fact those promises might represent separate obligations of the entity to the customer
In a multiple element arrangement, the amount of consideration allocated to a delivered element is limited to the amount that is not contingent on delivering future goods or services
Accounting for variable consideration differs greatly across industries
Under ASC 606
There will be consistent principles for recognizing revenue, regardless of industry or geography
The new guidance includes cohesive disclosure requirements to provide users of financial statements with useful information about the organization’s contracts with customers
Reporting organizations will identify each of the goods or services promised to a customer, determine if those goods or services represent a performance obligation, and recognize revenue as each performance obligation is satisfied
Companies will allocate the transaction process to each of the performance obligations in the contract on the basis of the relative standalone selling price of the underlying goods or services, except when a discount or variable amount of consideration relates entirely to one or more of the performance obligations in the contract
There will be a single model to consider for variable consideration, including rebates, discounts, bonuses or right of return (variable consideration will be included in the transaction price to the extent it is probable that a significant reversal of revenue recognized will not occur)
While contacts in the scope of Accounting Standards Codification (ASC) 944 — insurance is not within the scope of ASC 606, insurance and insurance-related companies often have revenue streams and provide services to customers that are not considered insurance contracts under ASC 944, therefore the adoption of ASC 606 may have a significant impact to these companies. Some examples may include:
Insurance entities often provide services that are separate and distinct from the underlying insurance or investment contract. Such services could include risk management type services, claims administration, property valuations or appraisals or financial planning. These services could be provided on a standalone basis from the underlying insurance contract. Further the performance obligations may differ for these services when compared to the performance obligations of the underlying contract (e.g. a property and liability contract with a one year policy term, but claims administrative services that cover claims related to that policy “cradle to grave”). As a result, the various performance obligations would need to be separately identified and assessed for the appropriate revenue recognition pattern for each performance obligation identified by the insurance entity. This creates challenges as often the transaction price for insurance intermediaries includes services for claims handing, policy endorsements, cash collections and risk management which are not separately priced under the terms of commission agreements. Such performance obligations will need to be separately analyzed for allocation of the transaction price to these performance obligations.
The FASB is expected to clarify that certain performance obligations that are partially in the scope of the new revenue recognition standard like claims adjustment and settlement services on high deductible policies will continue to be accounted for in their entirety under ASC 944.
Life insurers often sell investment-type contracts that are not accounted for as insurance contracts. These may be unit-linked contracts for which the customer pays for the financial instrument issued by the insurer and also for asset management services which reduce the policyholders’ initial deposit, as well as ongoing investment management fees that are drawn upon the periodic account balance of the investment contract. There are often additional charges or penalties when these investment contracts are surrendered. Under current GAAP this type of investment contract is accounted for consistent with other interest bearing or other financial instruments, however, there is no guidance describing the accounting for fees embedded in these contracts, however, these fees are often deferred and recognized similar to fees on universal life insurance contracts.
The FASB has discussed certain technical clarifications that are expected to broaden the current exclusion for insurance contracts within the scope of ASC 944 to include all contracts within the scope of ASC 944. It is expected this change will clarify that fees for the service component of investment contracts are outside the scope of the new revenue standard and are governed either by financial instrument guidance or by ASC 944.
Many insurance agency and claims handling contracts include elements of variable consideration (e.g. like profit commissions and performance bonuses) that are often determined based upon the ultimate outcome of a future event like profitability or of the line of insurance business written, for life contracts persistency bonuses or the amount of claims costs contained. Under the revised guidance, the transaction price only should include the estimated amount that is probable will be realized and will not result in significant reversal when the contingency is resolved. Current GAAP does not provide specific recognition guidance for this type of variable consideration. Accordingly, many insurance entities recognize such variable consideration when the contingency is resolved, often at contract end or based upon the amount that would be due if the contract were terminated at the financial reporting date.
Given the depth and breadth of the impact of this topic we believe insurance and insurance-related companies should continue to evaluate the impact of the adoption of this standard on their organizations. This could include changes to key operating metrics, information systems to capture data, assessing individual revenue streams, determining what services and products are currently being bundled (i.e. risk management and TPA services etc.) and assessing the need for additional internal controls over financial reporting.
The effective date of ASC 606 has been deferred by one year and as a result will be effective for the first interim period within annual periods beginning January 1, 2018 for calendar year-end entities (2019 for non-public companies following U.S. GAAP). ASC 606 provides the option to apply the standard retrospectively or to use a simplified transition method. If using the simplified method an entity will not restate prior periods.