When the changes to revenue recognition under ASC Topic 606 were introduced in 2014, it marked one of the most significant accounting changes in history. The goal of the standard update was to improve guidance on how revenue should be recognized when companies enter into contracts with customers.
It has been a few years since public and private companies adopted ASC Topic 606, but the standard continues to be challenge companies as evidenced by revenue continuing to be the number one area for restatements among public companies.
This article will look at the recent accounting update and explore challenges you may still be facing with reporting revenue recognition under ASC Topic 606.
Identifying Performance Obligations
One of the most significant ongoing issues with implementing revenue recognition is correctly identifying performance obligations. A performance obligation is a promise with a customer to transfer distinct goods or services within a contract.
A good or service is distinct if:
- The customer can benefit from the good or service on its own or with other readily available resources
- The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract
Generally a good or service is capable of being distinct if it is regularly sold on its own by the entity, however, this is not a definitive test of whether it is distinct. Rather, consideration should be given to whether the customer can benefit on their own from the good or service by using it, holding it to generate economic benefits or selling the good or service for an amount greater than scrap value. The evaluation of the benefit from the good or service includes subjective judgment. The evaluation does not need to be standalone in the context of the specific good or service and need not consider the customers intended use of the good or service; rather an entity should evaluate the benefit that can be received in the context of other goods or services that an entity has already transferred to the customer. The evaluation should also be based on the nature of the good or service itself and not the contractual limitations of the customer. It is possible that a good or service has a benefit to the customer in conjunction with other goods or services that are readily available from another party.
Often the evaluation of whether a good or service is distinct will hinge on how the good or service is used in the context of the contract. A good or service is not distinct in the context of a contract
when the good or service is an input in the creation of a single output of the contract. If a good or service is not distinct in the context of a contract then it is bundled with other promised goods or services until a distinct bundle is identified. The bundling of goods or services that are capable of being distinct, but that are not contractually distinct, is commonly seen in the construction industry, but may apply to any industry.
Principal vs. Agent Determinations
Another critical factor in the revenue recognition process is determining whether an entity acts as a principal or an agent. However, the evaluation can become challenging when a company takes something from a third party and integrates it to provide a good or service to a customer.
When multiple parties provide a good or service to a customer, ASC Topic 606 focuses on control of the specified goods and services as the overarching principle for entities to consider in determining whether they are acting as a principal or an agent.
An entity that determines it controls the good or service before transfer to a customer, a principal, records revenue on a gross basis. In contrast, an entity that determines it does not obtain control of the good or service before it is transferred to the customer, an agent, recognizes revenue on a net basis.
Three indicators help an entity determine whether it obtains control of a specified good or service, making it the principal in the transaction. They are:
- Primary responsibility for fulfillment
- Inventory risk before or after transfer to the customer
- Discretion in establishing a price
However, the control indicators are not a replacement for the assessment of control, which is the ability to direct the use and obtain all of the remaining benefits from the asset substantially.
Consideration Payable to a Customer
In some revenue transactions, an entity pays consideration to a customer or a customer’s customer, which may come in many forms, from slotting fees to coupons.
It’s important to determine whether the payment—in whole or in part—is made in exchange for a distinct good or service. If so, the accounting would be the same as for any other purchase made by the entity, as long as the consideration paid does not exceed the fair value of the goods or services received. If it does exceed, any excess is accounted for as a reduction in the transaction price. On the other hand, if the entity concludes the consideration paid to the customer is not in exchange for a distinct good or service, the entity would reduce the transaction price by the amount it pays or owes the customer.
While revenue recognition has many challenges, the updated process offers more transparency and allows for better comparability across reporting entities. If you have questions regarding ASC 606, please contact us.
Published on April 12, 2022