The new standard is effective for public companies for annual periods beginning after December 15, 2016 and interim periods within those annual periods. Early adoption is not permitted for public companies. It is effective for nonpublic companies for annual periods beginning after December 15, 2017 and interim periods within annual periods beginning in the following year. Early adoption is permitted at the public company effective date.
The new guidance will affect entities that enter into contracts with customers to transfer goods or services. The main objective is to standardize the revenue recognition guidance so that economically similar transactions are not recorded differently in financial statements which are in accordance U.S. Generally Accepted Accounting Principles (US GAAP).
The main provisions of the guidance are driven by the core principle 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. The guidance outlines the following steps an entity should follow when applying the new revenue recognition guidance under this topic.
Step 1: Identify the contract(s) with customer.
The new standard defines what constitutes a contract and also addresses how to account for modifications of contracts. Contracts under this guidance meet the following criteria:
- Approval and commitment of the parties
- Identification of the rights of the parties
- Identification of payment terms
- Contract has commercial substance
- It is probable that the entity will collect the consideration which is to be exchanged for goods or services transferred
Step 2: Identify the performance obligations in the contract.
The standard states that the entity should account for each promised good or service as a performance obligation if it is distinct or a series of distinct goods or services that are substantially the same and have the same pattern of transfer. A good or service is distinct if the customer can benefit from the good or service on its own or with resources that are readily available to the customer and if the promise to transfer the good or service is separately identifiable from other promises in the contract.
Step 3: Determine the transaction price.
The transaction price is the amount of consideration an entity expects to be entitled to in exchange for promised goods or services. An entity should consider variable consideration, estimates of variable consideration, existence of a significant financing component, non cash consideration, or consideration payable to the customer. The guidance provides specific examples and descriptions of types of consideration to be evaluated. The time value of money should be considered when a significant financing component exists.
Step 4: Allocate the transaction price to the performance obligation of the contract.
Now that a contract, performance obligation, and transaction price have been identified, an entity must allocate the transaction price to each distinct performance obligation of the contract. The guidance provides several options in executing this allocation. The allocation may be further complicated when considering variable consideration, noncash consideration, etc.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
As each distinct performance obligation is met, the allocated transaction price should be recognized as revenue. The guidance offers different approaches to recognize revenue if a performance obligation is satisfied over time or at a point in time. For example:
- If the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs,
- Or if the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced,
- Or if 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,
Then revenue may be recognized over time using the percent complete method, milestone method, or another method that represents the progress toward complete satisfaction of that performance obligation.
For obligations that are satisfied at a point in time, an entity should consider when control over the asset is transferred in a contract. Factors include whether:
- The entity has a present right to payment for the asset,
- The customer has legal title to the asset,
- An entity has transferred physical possession of the asset,
- The customer has the significant risks and rewards of ownership of the asset, or
- The customer has accepted the asset.
The statement also provides guidance on additional financial statement disclosures which allow financial statement users to understand the nature, amount, timing, and uncertainty of revenue and cash flows from contracts with customers. Additional qualitative and quantitative disclosures may be required under the new standard.
There are two methods of adopting the provisions of this statement:
- Retrospectively to each prior reporting period, or
- Retrospectively with the cumulative effect of initially applying the standard recognized at the date of initial application.
Under option one, the entity must be able to track, record, and report revenue under the provisions of this statement for up to two years prior to the implementation date. This may require a significant amount of planning and implementation of new processes and controls related to revenue recognition. Under option two, the entity should disclose each financial line item which is affected by the change in the current period and an explanation of reasons for specific changes.
The objective of the new standard is a more unified and consistent method of applying revenue recognition principles to US GAAP financial statements. Overall, ASU 2014-09 Revenue from Contracts with Customers is a substantial standard update which requires a detailed review of its provisions.
David Song can be reached at Email or 215.441.4600.
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