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New Guidance Significantly Changes Revenue Recognition in Financial Statements

New joint guidance issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) addresses one of the most important measures investors use when assessing a company’s performance and prospects — revenue. FASB’s version, communicated in Accounting Standards Update (ASU) No. 2014-09.

 

Revenue from Contracts with Customers, standardizes and simplifies the revenue recognition process for customer contracts across different industries and geographic locations. It also requires more comprehensive footnote disclosures for both public and private companies.

Although companies will ultimately report the same total amount of revenue over time, their performance could look different to investors as a result of changes in the timing of revenue recognition. Many companies are expected to record revenues earlier under the new guidance. This is because the guidance requires companies to estimate the effects of variable consideration, such as sales incentives, discounts, and warranties.

Almost every company will be affected in some way but companies in some industries are expected to feel the changes more than others.

The Origin of the New Converged Guidance

The converged guidance has been in the works for more than 10 years. U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) had divergent rules regarding revenue recognition, each with its own inconsistencies and weaknesses. GAAP, which had general rules along with more than 200 industry- and transaction-specific rules, produced different accounting for transactions that were economically similar. IFRS went to the other extreme — it provided limited guidance that required inadequate detail. Moreover, it was based on different fundamental principles.

Both the new GAAP guidance and the new corresponding IFRS rule are based on the following core principle: “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 the goods or services.”

5 Steps of Revenue Recognition

To help achieve that core principle, the new guidance lays out five steps a company must follow to determine when and how to properly recognize revenue on its financial statements:

1. Identify the contract with a customer. The guidance applies to each contract a company has with a customer, assuming the contract meets certain criteria. In some cases, the company should combine contracts and account for them as a single contract. The new guidance also includes rules for contract modifications.

2. Identify the company’s performance obligations (or promises) under the contract. If a contract contains obligations to transfer more than one good or service to a customer, the company can account for each as a separate performance obligation only if the good or service is distinct or if a series of distinct goods or services are substantially the same.

A good or service is “distinct” if a) the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer, and b) the company’s promise to transfer the good or service is separately identifiable from other promises in the contract.

3. Determine the transaction price. The company must determine the amount it expects to be entitled to in exchange for transferring promised goods or services to a customer. The new rules list several factors the company should consider, including the effects of any variable payments, significant financing components, non-cash consideration or consideration payable to the customer.

4. Allocate the transaction price to the performance obligations in the contract. The company will typically allocate the transaction price to each performance obligation based on the relative “standalone selling price” of each distinct good or service promised in the contract. If the standalone selling price is not observable, it must be estimated. Any discounts or variable payments that relate entirely to one of the performance obligations should be allocated to that obligation. The new guidance formally clarifies when an entity should allocate the discount or variable consideration to one or some performance obligation rather than to all obligations specified in the contract.

5. Recognize revenue when (or as) performance obligations are satisfied. The company must recognize revenue when it satisfies a performance obligation by transferring the promised good or service to a customer — that is, when the customer obtains control of the good or service. The amount recognized is the amount allocated to the performance obligation.

Notably, when a performance obligation is satisfied over time, versus at a single point in time, the company must likewise recognize revenue over time by consistently applying a reasonable method of measuring progress toward complete satisfaction of the obligation. 

Enhance Revenue-related Disclosures

Currently, most companies provide limited information about revenue contracts. The existing rules require only descriptions of a company’s revenue-related accounting policies and their effects on revenue, including rights of return, the company’s role as a principal or agent, and customer payments and incentives. Investors and other users of financial statements indicated that the disclosure requirements in both GAAP and IFRS were insufficient.

The new rules expand disclosure requirements for both public and nonpublic companies. The rules require a cohesive set of qualitative and quantitative disclosures intended to provide users of financial statements with additional useful information about the company’s contracts with customers including but not limited to impairments, existing contract balances, significant judgments and changes in those judgments by management, and assets recognized from the costs to obtain or fulfill a contract. The disclosures will include information about the nature, amount, timing, and uncertainty of revenue and cash flows arising from a company’s customer contracts.

For nonpublic companies, the FASB has modified the disclosure requirements related to: 1) disaggregation of revenue; 2) contract balances; 3) remaining performance obligations, assets recognized from the costs to obtain or fulfill a contract with a customer, and practical expedients; and 4) disclosure of judgments, assumptions, methods and inputs.

Impact on Industries

The new rules will likely have a particularly significant impact on certain industries, including those that commonly sell goods or services in bundled packages or enter into contracts that include variable payment terms, such as performance bonuses or rights of return.

For example, wireless providers (which may sell a customer a phone at the same time as a service plan) and software companies (which sell licenses to software along with future upgrades or other vendor obligations) may see accelerated recognition of revenue. Currently, these companies generally recognize revenue only to the extent they have actually received cash.

Software companies could also be affected by rules regarding recognition of royalties from licenses. The distinction between term licenses and perpetual licenses will be eliminated, with the focus shifting to the performance obligations under a license.

The licensing rules could affect media companies that collect sales- or usage-based royalties on intellectual property, as well. The new rules allow recognition of such revenue only when the underlying sale or usage occurs.

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