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Revenue Recognition Serial - Part 1: An Introduction to the Revenue Recognition 5-Step Process

Sept. 2, 2014

In May, the Financial Accounting Standards Board (FASB) issued FASB Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606). This has been the highly anticipated standard on revenue recognition that will supersede virtually all revenue recognition guidance currently found in U.S. generally accepted accounting principles (ASC 605, Revenue Recognition (Topic 605)). In addition to superseding Topic 605, Topic 606 will supersede virtually all industry specific guidance found throughout the Industry Topics of the FASB Codification.

While the new guidance may have minimal impact on some entities, the movement away from specific industry guidance is a significant change from current practice where industry guidance has been in use for decades. Additionally, on the surface, it appears that the new guidance contains less complexity than current guidance; however, the new guidance is considerably more principles-based and therefore can require significantly more judgment.

Scope

Topic 606 will be applicable to contracts with customers to transfer goods or services - except for transactions which are in the scope of other topics. Other topics that would still be applicable include leases, insurance contracts, certain financial instruments and other contractual rights and obligations (i.e. receivables, investments, debt, derivatives), guarantees and nonmonetary exchanges.

Effective Dates

The new guidance has different effective dates for public entities and all other (nonpublic) entities. A public entity is an entity that:

  1. meets the definition of a public business entity (see MHM Messenger 2014-02),
  2. is a not-for-profit entity that has issued, or is a conduit bond obligor for securities that are traded, listed or quoted on an exchange or an over-the-counter market, or
  3. is an employee benefit plan that files or furnishes financial statements to the SEC.

For those entities that meet one of the three criteria of a public entity, the guidance is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. 

For all nonpublic entities, the guidance is effective for annual reporting periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. This guidance may be applied early, but may not apply it earlier then the annual reporting period beginning after December 15, 2016, including interim periods within that reporting period (public-entity effective date).

MHM Messenger Serial

Due to the breadth and complexity of this standard and the need for entities to evaluate its impact on financial reporting, contracts and systems in preparation for implementing this standard, MHM's Professional Standards Group has created this Revenue Recognition Serial to provide information about the requirements of the standard and other considerations in these easier-to-read publications. The remainder of this issue will provide a high-level overview of the core principle of the standard. Future articles will include breakdowns of each step in the recognition process and disclosures, as well as other issues that will help you understand and begin to implement the standard.

Core Principle

The new guidance is based on this core principle:

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 good or services.

To achieve that core principle, an entity should apply the following steps:

  1. Identify the contract(s) with a customer.
  2. Identify the performance obligations in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to the performance obligations in the contract.
  5. Recognize revenue when (or as) the entity satisfies a performance obligation.

    (Source: FASB Accounting Standards Update No. 2014-09. May 2014)

5-Steps Overview

Understanding how to apply the 5-step process will be integral to the adoption of ASC 606. Following is a brief synopsis of each of the five steps above.

Step 1: Identify the Contract with a Customer

Contracts are agreements that create enforceable rights and obligations between two or more parties. For a contract to exist and be recognized by an entity under this standard it must meet five criteria:

  1. be approved by or be committed to by the parties,
  2. identifies the rights of the parties,
  3. contains payments terms,
  4. has commercial substance, and
  5. it must be probable that the entity will collect the consideration it is entitled to.

Other issues that may be evaluated in Step 1 of the revenue recognition process include combining contracts and modifying contracts.

Step 2: Identify the Performance Obligations in the Contract

Performance obligations are the promises to transfer a good or service to a customer. A contract may contain one or more promises and each contract is evaluated at inception to identify all of the performance obligations. To identify performance obligations, an entity will evaluate whether promises to transfer goods or services are distinct. If the good or service being evaluated is distinct, or if there are a series of distinct goods or services that are substantially the same and have the same pattern of transfer, then each good or service is accounted for as its own performance obligation. Goods or services that are not distinct are bundled with other goods or services until a distinct bundle is identified.

Step 3: Determine the Transaction Price

The transaction price, or the amount of consideration (i.e. payment) an entity expects to be entitled to in the contract from the exchange of goods or services, must be determined. The transaction price excludes amounts that are collected on behalf of third-parties.

There are five considerations that may impact the determination of the transaction price. The first is that some contracts include performance obligations that have variable consideration, in which case the entity must determine the expected or most-likely amount to be received in order to recognize revenue.

When variable consideration exists, an entity must evaluate the second consideration, which is the constraint on estimates of variable consideration. The recognition of some or all of the estimated variable consideration is only permitted to the extent it is probable that there will not be a significant reversal of the amount of cumulative revenue recognized.

The third consideration is whether the contract includes a significant financing component, which may be explicit or implicit in the contract. The existence of a significant financing component is evaluated whenever the practical expedient is not applied (i.e. when an entity expects at contract inception that the period between payment by the customer and the transfer of the good or service will be greater than one year).

The fourth consideration is the existence of noncash consideration.

The fifth consideration is whether there is consideration that is payable to the customer or other parties, such as purchasers of the customers goods or services.

Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract

When multiple performance obligations exist in a contract an entity will need to allocate the transaction price amongst the performance obligations to determine the amount it expects to receive in exchange for each performance obligation. The objective is to allocate the transaction price to each performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each performance obligation.

The allocation is determined at the inception of the contract and the basis used at that time is the basis for any future changes in the transaction price. The allocation is generally performed based on the relative standalone selling price for the distinct goods or services contained in the performance obligations at contract inception. Evaluating the standalone selling price may involve estimating the price when it is not observable. In addition, the standalone selling price for a performance obligation may be impacted by discounts or variable consideration related to one or more distinct goods or services.

Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation

The final step is the recognition of revenue when a performance obligation is satisfied by the transferring of the promised good(s) or service(s) to the customer. Transfer occurs when control is obtained by the customer - that control may be obtained in one of two ways: 1) over a period of time or 2) at a point in time. When revenue is recognized over time, an entity uses a consistent method to allocate the transaction price recognized over the period of time the performance obligation is completely satisfied based on an appropriate measure. Measures may include output or input methods and would incorporate updates as circumstances change over time.

Other Considerations

  • In addition to contracts with customers, Topic 606 modifies the accounting for transactions involving the sale of nonfinancial assets, such as property, plant and equipment and intangible assets, to be consistent with the recognition criteria of the new guidance.
  • Topic 606 also affects the accounting for costs related to a contract with a customer, requiring, in some instances, the capitalization of incremental costs to obtain and fulfill a contract.
  • Additional disclosure in the financial statements is required by Topic 606. For some entities the disclosure will require changes to systems to capture the required information.

To be satisfied over time a performance obligation must meet one of three criteria:

  1. The customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs.
  2. The entity's performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
  3. The entity's performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.

    (Source: FASB Accounting Standards Update No. 2014-09. May 2014)

All other performance obligations are considered to be satisfied at a point in time. The point in time that results in the recognition of revenue is when control is obtained over the good(s) or service(s) of the performance obligation by the customer. Indicators that control has been obtained by the customer may include:

  1. The entity has a present right to payment for the asset.
  2. The customer has legal title to the asset.
  3. The entity has transferred physical possession of the asset.
  4. The customer has the significant risks and rewards of ownership of the asset.
  5. The customer has accepted the asset.

    (Source: FASB Accounting Standards Update No. 2014-09. May 2014)

For More Information

If you have any specific questions, comments or concerns, please share them with James Comito of MHM's Professional Standards Group or your MHM service professional. You can reach James at jcomito@cbiz.com or 858.795.2029.


» Up Next

In the next edition of this Revenue Recognition Serial we discuss the considerations and factors that go into the evaluation of Step 1: Identifying the contract with the customer.

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