Revenue recognition is one of the accounting topics most examined by investors and regulators.
The core principle of the Financial Accounting Standards Board’s new revenue recognition standard is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to receive in exchange for those goods or services.
The revenue standard applies to all contracts with customers, except contracts within the scope of other standards, such as leases, insurance and financial instruments. Arrangements may also include elements that are partly within the scope of other standards and partly within the scope of the revenue standard. The elements that are accounted for under other standards are separated and accounted for under those standards. This is accomplished by a five-step process, as follows:
Step 1: Identify the Contract(s) with a Customer
Generally, any agreement that creates legally enforceable rights and obligations meets the definition of a contract. A contract creates legally enforceable rights and obligations, and meets all of the following criteria:
• Approval and commitment of the parties and are committed to satisfying their respective obligations.
• Identification of the rights of each party regarding the goods or services to be transferred.
• Identification of the payment terms for the goods and services to be transferred.
• The contract has commercial substance: the risk and timing of the entity’s future cash flows are expected to change as a result of the contract.
• 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. Only the customer’s ability and intention to pay are considered in evaluating whether collectability is probable.
Contracts can be oral, written, or implied by the entity’s customary business practices and written accounting policies. As part of identifying contracts with customers, management must also consider whether more than one contract with a customer should be combined and how to account for any subsequent modifications. If the contract meets the five criteria at inception, the entity will not reassess the existence of a contract unless there is a significant change in the facts.
If a contract does not meet the five criteria at inception, the entity needs to continue to assess whether or not a contract exists. Furthermore, if a contract does not meet the five criteria, but the entity has received consideration, revenue can be recognized when either the entity has no further obligation to transfer goods or services and all or substantially all consideration promised has been paid and is not refundable, or the contract has been terminated and any consideration already received from the customer is nonrefundable.
Step 2: Identify the Separate Performance Obligations in the Contract
Performance obligations are identified as having both of the following characteristics: each distinct item would meet the criteria for being satisfied over time and the same method would be used to measure the progress toward complete satisfaction of the performance obligation.
A good or service is distinct if both of 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.
• The vendor’s promise to transfer the good or service is separately identifiable from other promises in the contract.
If there is more than one good or service to be transferred, then the entity should account for each as a separate performance obligation only if the good or service is either:
• A good or service (or a bundle of goods and services) that is distinct.
• A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer.
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 includes only those amounts to which the entity has rights under the present contract. Management must take into account consideration that is variable, noncash consideration, and amounts payable to a customer to determine the transaction price. Management also needs to assess whether a significant financing component exists in arrangements with customers.
It is important to note that the transaction price excludes amounts collected on behalf of third parties such as sales taxes. An entity should also consider:
• Variable consideration: The consideration promised may include both fixed and variable components. Variable consideration is common and takes various forms, including (but not limited to) discounts, price concessions, rebates, refunds, credits, incentives, bonuses or penalties, royalties, and consideration an entity will receive that is contingent on a future event occurring or not occurring. The amount of variable consideration included in the transaction price may be constrained in certain situations. An entity should utilize either the expected value method or the most likely value method.
• Constraining estimates of variable consideration: The amount of variable consideration that can be included in the transaction price is limited to only those amounts for which it is probable that a significant reversal of the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variability is resolved.
• Significant financing component: An entity is required to adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods and services to the customer. In those circumstances, the contract contains a significant financing component.
• Noncash consideration: An entity should measure the noncash consideration at fair value. If fair value cannot be reasonably estimated, then the consideration is measured by reference to the standalone selling price of the promised goods and services. The revenue standard specifies that the measurement date for noncash consideration is contract inception.
• Consideration payable to the customer: If an entity pays consideration to a customer (such as cash, credit or some other items that reduce amounts owed to the entity by a customer), the entity should account for the payment as a reduction of the transaction price or as a payment for a distinct good or service, or both.
Step 4: Allocate the Transaction Price to Separate Performance Obligations in the Contract
The transaction price in an arrangement must be allocated to all separate performance obligations in proportion to the relative standalone selling price of the good or service underlying each of those performance obligations at contract inception. The best evidence of a standalone selling price is the price an entity charges for that good or service when the entity sells it separately in similar circumstances to similar customers. If a standalone selling price is not available, the entity will estimate it by maximizing the use of observable inputs consistent with the methods used for similar transactions with similar customers.
Acceptable methods for estimating the standalone selling price of a good or service include, but are not limited to, the following:
• Adjusted market assessment approach: A market assessment approach considers the market in which the good or service is sold and estimates the price that a customer in that market would be willing to pay. That approach also might include referring to prices from the entity’s competitors for similar goods or services and adjusting those prices as necessary to reflect the entity’s costs and margins.
• Expected cost plus a margin approach: This would be an entity’s expected costs plus an entity’s expected margin. Both direct and indirect costs should be considered, but judgment is needed to determine the extent of costs that should be included.
• Residual approach, in limited circumstances: An entity may estimate the standalone selling price in reference to the total transaction price, minus the sum of the observable standalone selling prices of other goods and services promised in the contract.
A combination of methods may be used to estimate the standalone selling prices if two or more of those goods or services have highly variable or uncertain standalone selling prices. Discounts or variable consideration that relates entirely to one performance obligation should be considered and possibly allocated to just that performance obligation, or just to some of the performance obligations instead of all performance obligations in the contract.
Step 5: Recognize Revenue when the Entity Satisfies Each Performance Obligation
Revenue is recognized when or as each performance obligation is satisfied by transferring control of a promised good or service to a customer. Control represents the ability to direct the use of, and receive the benefits from, a good or service. Control either transfers over time or at a point in time, which affects when revenue is recorded. Indicators of obtaining control by the customer include the customer presently is obligated to pay, has legal title, has physical possession, and has the significant risks and rewards of ownership of the asset.
An entity transfers control of a good or service over time if one of the following criteria is met:
• The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
• The entity’s performance creates or enhances an asset (e.g., work in process) that the customer controls as the asset is created or enhanced.
• The entity’s performance does not create an asset with an alternative use to the entity, and the entity is entitled to payment for performance completed to date.
The amount of revenue recognized for goods and services satisfied over time should be determined using a consistent method of measuring the progress toward completion.