The new revenue recognition standard (ASC Topic 606) represents a complete overhaul and almost complete rework of all the existing revenue literature currently being used under U.S. Generally Accepted Accounting Principles. The new guidance will require a significant amount of work by companies to implement, and it is important that Audit Committees and other stakeholder understand it.
|“Implementation of the new standard requires significant effort by companies, including analyzing contracts and designing new systems, processes, and controls. Given the importance of high quality application of the standard, I believe executive management, the audit committee, and the company’s external auditor should discuss implementation status and plans, as well as the allocation of sufficient resources with appropriate skill sets to execute the plan.”
– James Schnurr, Securities and Exchange Commission
(SEC) Former Chief Accountant, 12th Annual Life Sciences
Accounting and Reporting Congress, March 22, 2016
The driving principle of the Standard is that “an entity should 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.” In order to do this, the standard setters have laid out a process that all companies must go through in order to identify, evaluate and recognize revenue.
Recognition of revenue requires companies to complete a five-step process. These steps are:
Depending on the complexity of the company’s revenue contracts and customer relationships, each of these steps can be highly complicated and highly subjective. Judgment must be used in each step, and that judgment must be supportable under the circumstances.
Step 1: Identify the Contract(s) with a Customer
The new standard defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. Generally, a contract should be accounted for when all of the following criteria are met:
- It has the approval and commitment of the parties.
- Rights of the parties are identified.
- Payment terms are identified.
- The contract has commercial substance.
- Collectability of substantially all of the consideration is probable.
Much of the above criteria contain inherent judgements that will have to be made and policies that will have to be developed to support them. Complications may also arise with multiple contracts that may need to be accounted for as a single contract or when it is difficult to determine who the actual customer is.
Step 2: Identify and Separate the Performance Obligations in the Contract
The new standard requires that a company assesses the goods or services promised in a contract with a customer at contract inception. Each promise to transfer one of the following to the customer is generally considered a performance obligation:
- A good or service (or a bundle of goods or services) that is distinct
- A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer
Step 3: Determine the Transaction Price
The transaction price is the amount of consideration to which an entity expects to be entitled to in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. Significant judgements and considerations may include:
- Variable consideration
- Constraining estimates of variable consideration
- The existence of a significant financing component
- Noncash considerations
- Consideration payable to the customer
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
When allocating the transaction price, the objective is for an entity to allocate the transaction price to each separate performance obligation (or distinct goods or services) in an amount that depicts the amount of consideration to which the entity expects to be entitled to in exchange for transferring the promised goods or services to the customer.
Step 5: Recognize Revenue When the Entity Satisfies a Performance Obligation
The company should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. An asset is transferred when (or as) the customer obtains control of that asset.
The concept of obtaining control requires significant judgement and requires that the company satisfies the obligation over time or at a point in time.
Implementation of the new standard is complex and requires a significant amount of planning and upfront design work. The standard impacts almost all companies and significantly changes the landscape around revenue recognition.
If you would like further information regarding the services we provide on implementing the new revenue standard, please contact Elberta Nizzoli at: email@example.com or at 310-477-3924