Prepare Now for Revenue Recognition Implementation
In May, 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, (Topic 606). The Update takes effect essentially in 2017 and establishes a comprehensive revenue recognition standard for almost all of the various industries. Prior to the promulgation of this standard, certain companies followed their industry-specific revenue recognition standards such as software and real estate.
Revenue is an important number to users of financial statements in assessing an entity’s financial performance and position. However, previous revenue recognition requirements in US Generally Accepted Accounting Principles (GAAP) differed from those of International Financial Reporting Standards (IFRS). Hence the FASB is making these amendments to the Accounting Standards Codifications (ASC), and the International Accounting Standards Board (IASB) is issuing IFRS 15, Revenue from Contracts with Customers.
The issuance of these documents completes the joint effort by the FASB and the IASB to meet the objectives of removing inconsistencies and weaknesses in revenue requirements, provide more useful information to users of financial statements through improved disclosure requirements and generally improve financial reporting by creating common revenue recognition guidance for US GAAP and IFRS.
Summary of the New Rules
Under the new rules companies will follow a five-step approach to apply the standard:
Step 1: Identify the contract(s) with the customer. A contract is an agreement between parties that creates enforceable rights and obligations. It can be written, oral, or implied by an entity’s customary business practice. Generally, any agreement that creates enforceable rights and obligations will meet the definition of a contract.
Step 2: Identify the separate performance obligations in the contract. A performance obligation is a promise to transfer a distinct good or service (or a series of distinct goods or services that are substantially the same and have the same pattern of transfer) to a customer. The promise can be explicit, implicit, or implied by an entity’s customary business practice. The objective of identifying distinct performance obligations is to describe the transfer of goods or services to the customer.
Step 3: Determine the transaction price. The transaction price is the amount of consideration that an the company expects to be entitled to in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of a third party. Determining the transaction price will be more complex if the contract involves variable consideration, a significant financing component, or noncash consideration.
Step 4: Allocate the transaction price to separate performance obligations. The transaction price is allocated to the separate performance obligations in a contract based on the relative standalone selling prices of the goods or services in the contract. The allocation is made at contract inception and not adjusted to reflect subsequent changes in the standalone selling prices of those goods or services. The best source of standalone selling price is the observable price of a good or service when the entity sells that good or service separately.
Step 5: Recognize revenue when (or as) each performance obligation is satisfied. The new revenue recognition model culmination is recognizing revenue. A company will recognize revenue when (or as) a good or service is transferred to the customer and the customer obtains control of that good or service. Control of an asset refers to a company’s ability to direct the use of and obtain substantially all of the remaining benefits (that is, the potential cash inflows or savings in outflows) from the asset. Directing use of an asset refers to a customer’s right to deploy that asset, to allow another entity to deploy that asset in its activities, or to restrict another entity from deploying that asset.
- For a public entity, the amendments are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted.
- For all other entities (non-public entities), the amendments are effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Early application is permitted under certain circumstances.
- An entity should apply these amendments using one of the following two methods:
- Retrospectively to each prior reporting period presented
- Retrospectively with the cumulative effect of initially applying this standard recognized at the date of initial application.
Even though implementation seems far away, it is highly recommended that companies begin to prepare now for implementation
The new standard will likely affect the measurement, recognition and disclosure of revenue, which is often the most important financial performance indicator. Since an entity’s objective is to generate revenue, it is not surprising that changes to the accounting for revenue could affect multiple business functions. To prepare for implementation companies should:
- adjust or add controls to address increased judgments and estimates in revenue amounts, including documentation and testing of those new controls
- update policies and procedures to conform to the new standard,
- consider internal controls optimization for all revenue-related controls.