On May 14, 2014 the FASB issued the standard ASC 606 Recognition of Revenue from Contracts with Customers. It is a converged standard with the IASB (IFRS 15) The FASB issued an Accounting Standards update to the Standard (ASU 2016 -10) in April 2016.
The implementation date for the standard is:
- For public business entities, certain not-for-profit entities, and certain employee benefit plan
- Reporting periods beginning after Dec 15, 2017
- For all other entities
- Reporting periods beginning after December 15, 2018
ASC 606 will have a major impact on the reporting of revenue for all entities, public and private that enter into contracts that promise the exchange of goods and services to their customers with a relatively minor impact on some costs associated with fulfillment of the contracts.
The standard is both complex and far reaching. It impacts not only marketing groups but lilely other groups, for example R&D, that enter into collaborative or other contracts or arrangements with third parties. As a result implantation is likely to require considerable effort and expertise.
Entities that plan to report GAAP financials, both public and private, if they have not already done so, would be well advised to consider moving quickly to initiate a thoughtful plan of action to comply with the standard.
Overview of the Standard
The following reviews the authors view of the high points in the standard.
The basic economic transaction addressed by the standard is the contract between an entity and its customers. The standard address the accounting for the promises embodied in the contract, which it refers to as performance obligations.
The core principle of the standard is that an entity recognizes revenue to depict the transfer of the promised goods or services in amounts and timeframe that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services when (or as) the said goods and services are delivered or fulfilled.
To achieve the core principle the standard promulgates a series of action that an entity must undertake to determine the amount and timing of revenue to be recognized. These are:
- Identify the contract with the customer
- Identify the distinct performance obligation(s) in the contract
- Determine the transaction price
- Allocate the transaction price to the distinct performance obligations in the contract
- Recognize revenue when (or as) the entity satisfies the performance obligation(s)
1) Identify the Contract
The contract with the customer is a central aspect of the standard as revenue recognition flows directly from it. Without a contract there can be no revenue recognized under this standard. Evidence that a contract exists is based on:
- Approval: All parties to the contract have approved the contract (in writing, orally or in accordance with customary business practices)
- Rights: The contract clearly identifies the rights of the parties
- Payment: The payment terms are clearly stated
- The contract has commercial substance (i.e. parties cannot agree to artificially swap goods or services in order to boost revenue)
- Probability: It is probable that the contract terms will be honored
Note that that new standard by requiring clear identification of the parties’ rights brings a focus on legal enforceability. Therefore, a contract will exist once legal enforceability exists, even if it differs from an entity’s normal and customary business practice.
2) Identify the Distinct Performance Obligations in the Contract
Where a contract recites the transfer of more than a single good or service then the seller must evaluate the goods and services to be transferred as to whether any of them are distinct.
A distinct good or service (or bundle of services) is considered a performance obligation. To be distinct the goods of service must be identified in the contract and be capable of performing a service as delivered or in combination with other services that the customer could readily find.
Note that the drafters and approvers of the contract will, normally be careful to ensure that the contract recites the agreed performance obligations.
This section of the standard generated many comments and questions to the extent that the FASB, in 2016 issued an Accounting Standards Update (ASU) that offered further interpretive guidance (ASU No 2016 -10) April 2016 about Identifying distinct performance obligations and licensing
The ASU provided clarification as follows:
Distinct Goods or Services
A good or service that is promised to a customer is distinct if both the following criteria are met:
- The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is the good or service is capable of being distinct)
- The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract
The ASU provided further guidance as follows:
In assessing whether an entity’s promise to deliver separately identifiable services to a customer are distinct the objective is to determine whether the nature of the promise, within the context of the contract is to transfer each of those goods or services individually, or instead, to transfer a combined item or items to which the promised goods or services are inputs.
The ASU goes on to cite factors that merit consideration in making the determination. One such factor cited is the instance where “ The goods or services are highly interdependent or interrelated, In some cases two or more good or services are significantly affected by each other because the entity could not be able to fulfill its promise by transferring each of the good or services independently.”
The above situation would seem to be evidence that the goods or services merit treatment as a combined item
- An entity is not required to assess whether goods or services are performance obligations if they are immaterial to the contract
- Promised goods or services do not include the various administrative activities the vendor must perform to setup a contract as those tasks do not transfer services to the customer
Shipping and handling
- An entity that promises a good to a customer might perform shipping and handling related to the good. If the shipping and handling occur before the customer has control of the good then the shipping and handling is not a performance obligation but rather an activity to fulfill the entity’s promise to transfer the good
- However if the shipping and handling activities occur after the customer has obtained control of the good the entity is permitted as an accounting policy election to account for them as an activity to effect transfer of the goods rather than as an additional promised service
An entity may combine one or more contacts entered into at or about the same time with the same customer and account for them as a single contract if one or more of the following criteria are satisfied:
- The contracts are negotiated as a package with a single commercial objective
- The goods and services promised in the contracts constitute a single performance obligation
- The consideration paid in one contract is dependent on the price or performance of the other contract
3) Determine the transaction price
Determining the transaction price as of the inception of the contract may not be straightforward. The price may be subject to discounts, rebates, penalties and/or performance bonuses, which cannot be precisely quantified at the contract inception. However, even if not straightforward it is incumbent on the entity to estimate the price. The standard present certain approaches:
- Most likely price. The seller develops a range of possible prices and selects the most likely
- Expected value of the price. The seller develops a range of possible prices, assigns a probability to each and derives the expected value
Whichever method is chosen the seller should apply it consistently throughout the contract and for similar contracts.
Note also that the standard addresses other matters that could complicate price determination such as:
- Payments over a period of time – price is deemed to include a financing component which must be accounted for separately
- Non cash consideration – fair value of the consideration must be determined
- Payments in advance – are not revenue but a liability
4) Allocate the transaction price to the performance obligations
In this step the entity determines the stand-alone selling price of each performance obligation as of the inception of the contract. The best evidence of that price would be an observable price of the good or service when the seller sells it to a similar customer under similar circumstances.
If it is not possible to observe a stand-alone price the entity must estimate it. The following represents possible acceptable ways to estimate a stand-alone selling price:
- Adjusted market assessment: Reviewing the market for like products and their pricing
- Cost plus margin: the seller estimates their cost and adds an appropriate margin
- Residual approach: subtract the determined standalone price(s) from the contract price and apply that difference to the other obligations. This approach can be difficult to use.
Once the seller derives an approach for estimating stand-alone selling prices it should apply that approach consistently for other goods or services with similar characteristics.
It can turn out that the sum of the estimated standalone prices exceeds the contract price in which case the customer is deemed to have received a discount. The discount should be allocated across the performance obligations in proportion to their standalone price except there is evidence that the discount should be applied to one or more specific obligations
5) Recognize revenue when (or as) the entity satisfies the performance obligation
Revenue is to be recognized when (or as) goods or services are transferred to the customer. The transfer is considered to have occurred when the customer has gained control over the good or service, that is, when the customer has taken on the significant risks and rewards of ownership, for example, the seller can sell, pledge or exchange the asset.
It is possible that a performance obligation will be transferred over time rather than at a point in time. Service contracts or construction contracts are example of performance obligations transferred over time. The seller’s entitlement to payment will be controlled by the contract terms, for example, when milestones are reached and/or when the customer is satisfied with a deliverable or other criteria specified in the contract.
Costs incurred to obtain a contract.
An organization may incur costs to obtain a contract. If so, it is allowable to capitalize these costs and amortize then over the life of the contract provided:
- The costs are incremental: An example would be sales commissions
- There is an expectation that the costs will be recovered
- Note that if the amortization period will be one year or less it is allowable to expense these costs as incurred
An entity may incur costs to fulfill a future performance obligation. In general such costs should be recognized as assets if they meet the following criteria:
- The costs are tied to a specific contract
- The costs are incurred to satisfy a future performance obligation
- There is an expectation that the costs will be recovered
A warranty is a guarantee related to the performance of a delivered goods or service. In general there are two types of warranty:
- The seller warrants the goods or service at no cost to the customer. The seller accounts for the warranty cost by establishing a reserve based on prior experience and adjusts it over time to reflect more current experience
- The seller offers the option to the seller of separately purchasing a warranty. As such the warranty is considered a separate performance obligation
An entity may offer a customer a license to use intellectual property owned by the seller. If a contract contains both a licensing agreement and a provision to provide goods and services the seller must identify each performance obligation in the contract and allocate the transaction price.
ASU No 2016 -10 April 2016 Identifying Performance Obligations and Licensing) provided updated guidance on accounting for licenses. That is:
- On whether an entity’s promise to grant a license provides the customer with a right to use the entity’s intellectual property (which is satisfied at a point in time) OR to access the intellectual property (which is satisfied over time)
- On the recognition of revenue for a usage or sales based royalty in exchange for a license of intellectual property. Essentially the ASU disallows the splitting of the royalty into a portion based on sales or usage and a portion that is not subject to that guidance
ASC 606 requires considerably more disclosures about revenue. In general, the intent of the disclosures is to enable the reader to understand the nature and amount of the revenue being recognized and the uncertainty of the related cash flows. More specifically the entity shall disclose:
- Disaggregation of revenue
- Contract Balances
- Performance Obligations
- Transaction price allocated to remaining obligations
- Significant judgments made in the application of the standard
- Practical Expedients relied upon e.g.
- Existence of a financing component in the contract
- Incremental costs of obtaining a contract
The standard provides guidance on several other situations that can arise in the administration of contracts. For example (Not a complete recap:)
- Measurement of progress completion
- Change in estimate
- Right of return
- Contract modification
- Bill and hold arrangements
- Cash and non cash consideration
Given the complexity of this standard and its impact on revenue, a most critical financial metric it is incumbent on entities to have a well thought out implementation and transition plan. Some key issues that the plan should address include:
- Financial: Determine the revenue streams that are impacted. Assess the need to review all customer contracts, possibly cataloging them and detailing their performance obligations.
- Review the methodology in place for recognizing revenue and devise an intervention whether interim or final, systematic or manual, that brings revenue recognition into line with the standard
- If the plan includes significant manual effort be aware of the increased probability of errors and mitigate it with adequate quality controls
- Information System: Ascertain the need and /or feasibility of reconfiguring the ERP system to seamlessly produce financial information in compliance with the new standard
- Organization: Communication to internal and external stakeholders. Determine the need for revised guidance to organization units that interface with customers or suppliers with regard to entering into structuring of and reporting on contracts.
- Transition: Decide on and prepare for full retrospective or modified retrospective presentation for financial statements presented after the implementation date. I.e.
- Full retrospective: Apply the new standard as of the implementation date and, for the prior comparative periods, restate all contracts on the same basis
- Modified retrospective: Apply the new standard as of the implementation date and, for the prior comparative periods, the data is not recast but instead apply a single adjustment to equity at the beginning of the initial year of application.