Five steps to adopt the new revenue recognition standard
The new revenue recognition standard is here, and the time to implement those standards is now. As we discussed in our previous post, the standard set forth in IFRS 15 and FASB Topic 606 applies to almost all public and private companies and involves a whole new paradigm for how contractual revenue is recognized and reported. Public companies should be applying the standard already, while private companies must apply the new revenue recognition standard to annual reporting periods beginning after December 15, 2018.
Fundamentally, the new standard involves a five-step process which needs to be applied to determine how contractual revenue is accounted for:
Step 1: Determine whether there is a contract.
Do you and your customer have an understanding? An agreement to agree? Or, do you and your customer have a legally binding contract which sets forth enforceable rights and obligations? Those are the foundational questions which need to be answered to determine whether the revenue generated falls under the new standard.
The Board identified certain required attributes an arrangement must have to constitute a contract within the scope of the standard:
- The parties have approved the contract and are committed to perform their respective obligations.
- Each party’s rights regarding the goods or services to be transferred can be identified.
- Payment terms can be identified.
- The contract has commercial substance.
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Step 2: Identify the performance obligations in the contract.
A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. If an entity promises in a contract to transfer more than one good or service to the customer, the entity should account for each promised good or service as a performance obligation only if it is (1) distinct or (2) a series of distinct goods or services that are substantially the same and have the same pattern of transfer.
A good or service that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct.
Step 3: Determine the Transaction Price.
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (such as sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.
Determining the transaction price requires an analysis of several factors which can impact when and how customer payments are due under the agreement. Specifically:
- Variable consideration
- Constraining estimates of variable consideration
- The existence of a significant financing component
- Noncash consideration
- Consideration payable to the customer
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract.
Now that you have the obligations and transaction price figured out, you need to allocate the latter to the former. To do that, an entity must determine the standalone selling price at contract inception of the distinct goods or services underlying each performance obligation and would typically allocate the transaction price on a relative standalone selling price basis. In other words, break down each obligation as if it were a separate agreement and allocate the amount you would charge for such an individual obligation
Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation
An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. For each performance obligation, an entity should determine whether the entity satisfies the performance obligation over time by transferring control of a good or service over time. If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.
If, however, the obligation is performed over time, the revenue can be recognized over time as well since the customer is receiving promised benefits over time.
Guidance is sometimes needed in the steps within steps
The foregoing is an extremely broad and high-level look at the five steps involved in applying the new revenue recognition standard. Each industry, each company, and each contract can raise nuanced challenges and require additional analyses in terms of how each step is to be accurately performed.
Meeting those challenges and conducting those analyses is no small step. We can help you understand the new recognition standard and work with you to develop compliant policies and procedures. Please feel free to contact us with questions or concerns or for assistance.