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The 5 Steps to Revenue Recognition

8/15/2014

1 Comment

 
Published by Stefanie Hatch 

On May 28, 2014, the FASB and IASB released a new global revenue recognition standard. The standard is meant to reconcile revenue recognition across multiple industries, and is used to replace all current standards of recognition. The new standard requires the use of more estimates and judgment than the previous standards. The effects are likely to involve significant changes to an entity’s guidelines and processing.

The standard affects all entities. The following five steps describe the process that each entity must go through to estimate revenue under this new standard. It also applies to sales of non-business items such as tangible and intangible assets.

Step 1: Identify the Contract with the Customer

Contracts with customers under the new standard can be written, oral, or implied. A significant amount of judgment on the part of management is required to determine when an actual contract is started. The standard sets out five criteria for a contract:
  1. Approval and commitment of the parties
  2. Identification of the rights of the parties
  3. Identification of the payment terms
  4. The contract has commercial substance
  5. It is probable that the entity will collect the consideration

The contract does not exist if either party to the contract can unilaterally cancel the contract without penalty or neither party has performed. If there are several contracts related to one customer, the contracts can be combined.

Step 2: Identify the Performance Obligation in the Contract

A performance obligation under the new standard is an explicit or implicit promise to deliver a good or service. The standard does not distinguish between what is considered a paid for good or service and what is considered a free good or service. Under this standard, the company must consider any and all activity included in the sale, regardless of whether it is included in the contract.

The standard includes a new practice of separating performance obligations into distinct or non-distinct areas for revenue recognition. A distinct item is any item that can support a sale with no further work. A non-distinct item cannot be sold on its own and must be combined with other items. Items included in the contract must be considered distinct on a regular basis and in accordance with the contract.

An example of this would be the sale of large manufacturing equipment. The equipment generally comes with installation services. The equipment would be considered a distinct item, as these items can be sold anywhere and installed by anyone. Consider, though, if the installation of these items requires specialized knowledge only provided by the selling company. In this case, the equipment alone wouldn’t be distinct and would then need to be bundled with the installation.

Step 3: Determine the Transaction Price

The transaction price is the amount of consideration to which an entity expects to be entitled in relation to goods or services provided, excluding any amounts received for a third party. This includes any variable consideration, such as a performance bonus, discounts, rebates, any financing received, consideration paid directly by the customer, and any noncash items received. The company must also take into account any possible returns and price concessions made on the sale. If there is a significant probability of return, only the amounts for which it is probable that a significant reversal of cumulative revenue will not occur are included in the transaction price.

Revenue will be recorded based on either the probability-rated amount or the most likely outcome. An example of this would be a performance obligation that includes a $10,000 bonus on top of an existing sale. This amount must be taken into account at the front end of the sale, and not when the performance obligation is met. If this performance obligation is binary, in that the company will receive the whole amount or none, the company will include this total in the sale if it is “more-likely-than-not” that the obligation will be met.

If the amount is not binary, the company will consider how likely it would be to meet each obligation. As shown in the graph below, the calculated amount based on spread probabilities is $6,200. This amount would be recognized at the front end of the sale.
Possible Outcome
10,000
8,000
6,000
4,000
-
Probability
15%
30%
25%
20%
10%
Calculated Amount
1,500.00
2,400.00
1,500.00
800.00
-
Step 4 – Allocating the Transaction Price to the Performance Obligations in the Contract

The consideration given on the contract must be allocated to each distinct or set of distinct performance obligations. The standard states that the allocation is to be made based on the standalone selling price of the item. If there is not a known standalone selling price, management must estimate how the transaction price will be allocated. Significant judgment is required by management in making these allocations. Standalone selling prices should not be adjusted after inception of the contract.

Step 5 – Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation

The standard gives five indications of whether a performance obligation has been met. Note that these are indicators and not criteria. Management must use judgment to determine whether revenue is to be recognized.

  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

When Will the Amendments be Effective?

For public entities, the standards will become effective for annual periods beginning after December 15, 2016, including interim periods within that reporting period. Public entities cannot early adopt. For private entities, the standards will become effective for annual periods beginning after December 15, 2017. Private entities can choose to early adopt using the same effective date for public companies.

There are two adoption methods for applying the new standard. In the first method, retrospective application is made to all periods presented.  This method also includes several practical expedients.

The second method requires application to any incomplete contracts in the year of adoption. Any contract that is not complete when the method is adopted must be recalculated using the new method. The cumulative effect of the changes is shown in the beginning retained earnings. This method basically requires keeping two sets of books on any contract that is expected to be in effect when the change is made. Disclosures would include showing the effect on each line item, as well as the reasons and method for the change.

What Does This Mean for Me?

All entities should begin to prepare for the changes as soon as possible. Preparation could include reviewing current sales and contract standards, determining any training needed on the part of sales and accounting personnel, reviewing the current accounting system, and considering if adjustments are needed in how information flows from sales personnel to the accounting system. Entities can also begin determining a standalone pricing to use on regular contract items to ensure a smooth transition to the new standard.

If you found this post helpful or still have questions, please comment. If you would like more information about this, please contact us.

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