The Financial Accounting Standards Board (FASB) first introduced the Accounting Standards Update (ASU) 2014-09 in May 2014, which led to the establishment of the Accounting Standards Codification® (ASC) Topic 606, Revenue from Contracts with Customers (Topic 606).
A decade later, all companies reporting under generally accepted accounting principles (GAAP) are required to recognize revenue in accordance with Topic 606, including professional services companies. As a result, professional services companies must apply significant judgment to determine the timing and amount of revenue recognized from their contracts with customers.
Topic 606 contains extensive disclosures related to a company’s contracts with customers—both quantitative and qualitative. Successfully comply with Topic 606 with insights into its approach, considerations for first-time reporters, and the lessons learned since 2014.
Prior to the adoption of Topic 606, recognition of revenue was generally based on when the risk of loss from the sale of goods or services was transferred to the customer. Topic 606 shifted revenue recognition to be based on the transfer of control over the goods or services to the customer. Specifically, revenue is recognized upon the transfer of the specified good(s) or service(s) to the customer in an amount the entity expects to be entitled to receive from the customer.
Topic 606 uses a five-step model to increase financial reporting comparability across industries, done so through the application of a uniform framework for revenue recognition. This process promotes consistency in revenue recognition across industries, providing clearer insights into financial performance.
Refer to our Revenue Recognition Guide
For companies that will be reporting revenue in accordance with Topic 606 for the first time, the impact of the guidance is complex and expansive, involving many different functions within an organization.
Business areas that may be impacted include:
Every entity is affected differently, but in several situations, the standard may result in:
These are generalizations—the exact effects of the new standard may differ for each individual business and should be carefully evaluated.
There are four phases of implementation that professional services companies are likely to find helpful when adopting ASC Topic 606 for the first time.
The following is an overview of the most common types of contracts professional services companies use and how accounting for the associated revenue is conducted under Topic 606.
These types of contracts are typically based on the actual time incurred on a project charged at one or more specified hourly rates. These contracts can be short-term or extend over multiple reporting periods.
A performance obligation is a contractual promise to provide a good or service, or a bundle of goods or services, that is distinct. Careful consideration should also be given to a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. A promised good or service is capable of being distinct if the customer can benefit from it either on its own or with other readily available resources, and if the promise to transfer a good or service is distinct within the context of the contact.
To determine if a promise is distinct within the context of the contact, an entity should consider if the purpose of the promise is to transfer individual goods or services or a combined item for which individual goods or services are inputs. Factors that indicate two or more promises to transfer goods and services aren’t distinct within the context of the contract include, but aren’t limited to:
If there’s more than one performance obligation, the transaction price is allocated to each performance obligation based on the relative standalone selling price at contract inception.
However, if a particular performance obligation isn’t sold on a standalone basis or if the standalone selling price isn’t directly observable, the standalone selling price will need to be estimated. If pricing for the performance obligation isn’t highly variable or uncertain, the standard states the following two techniques may be used to estimate the standalone selling price:
If pricing for the performance obligation is highly variable or uncertain, the standard allows for the residual approach to be used in select circumstances, where the observable standalone selling prices are deducted from the total transaction price to estimate the standalone selling prices of the remaining goods or services. The amount allocated under this method must still reflect the consideration to which a company expects to be entitled in exchange for a good or service.
The process for allocating the transaction price to the distinct performance obligations is based on a relative standalone selling price approach.
Determining a standalone selling price can be straightforward if the company routinely sells the good(s) or service(s) on a standalone basis. However, if not, then an entity will have to estimate the standalone selling price using one of the three methods, as shown in the chart below.
These methods are described in detail on page 23 of our Revenue Recognition Guide.
A contract that’s based on a predetermined, set dollar amount is a fixed-fee agreement.
Similar to the “actual time incurred” contracts discussed above, the number of performance obligations within fixed-fee contracts also needs to be determined. There may be more than one, even if the customer pays a single fee.
Revenue should be recognized when the performance obligation is satisfied by transferring to the customer the promised good(s) or service(s). Revenue may be recognized over time or at a point in time, depending on when the customer obtains control of the good(s) or service(s). Control is generally deemed to be transferred over time when:
If none of the above criteria are met, control would be deemed to be transferred at a point in time.
Companies need to consider all relevant facts and circumstances when determining when control is transferred to the customer, and the pattern of revenue recognition needs to be determined at contract inception.
If a contract involves more than one party providing goods or services to a customer, it’s likely to require further evaluation of the specific circumstances in order to determine whether the company is a principal or an agent as this will determine if revenue should be presented gross or net.
The accounting treatment for such contracts focuses on the concept of control, which is explained in the table below.
When determining whether a revenue stream requires a technical assessment, it’s necessary to consider the following.
Under Topic 606, variable consideration—such as an incentive, bonus, rebate, or discount—that’s promised within a contract must be considered when determining the transaction price.
Variable consideration should be determined using either the best estimate or expected value approach, whichever method is expected to better predict the amount of consideration to which an entity will be entitled. However, variable consideration should only be included in the transaction price if it’s probable a significant revenue reversal won’t occur.
As a result, some entities may recognize variable consideration sooner under Topic 606 than under prior GAAP.
The most likely amount is the single-most likely amount in a range of possible amounts. This means it’s the single most likely outcome of the contract. The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes.
Management will also need a process to evaluate and document significant contract modifications. A contract modification is an approved change in the scope or price of a contract that creates new enforceable rights and obligations or changes the existing enforceable rights and obligations. Contract modifications are often referred to and executed as amendments or change orders and may be implied by customary business practices or approved orally or in writing – the key is whether it is legally enforceable.
In some cases, the modification will be treated as a separate contract and won’t affect revenue recognized on the original contract in any way. In other situations, a company will be required to treat a contract modification as a termination of the existing contract and the creation of a new replacement contract. In still other cases, a company will account for a contract modification by recording a catch-up journal entry to adjust the cumulative revenue recognized to date on the contract. The ultimate accounting treatment will depend on the nature of the modification.
Incremental costs of obtaining a contract with a customer within the scope of Topic 606 are deferred and recognized as an asset if the entity expects to recover the costs under ASC Subtopic 340-40, Other Assets and Deferred Costs: Contracts with Customers (Subtopic 340-40).
Whether you are complying with GAAP for the first time or have been doing so for years, here are a few matters that companies should consider as they report revenue in accordance with Topic 606.
Companies may note an acceleration of revenue recognition under Topic 606, particularly firms that previously recognized revenue based on time billed. Under Topic 606, revenue is typically recognized when the service is provided—time incurred—versus when the invoice is sent to the client.
Companies also must assess the impact of recognizing revenue in accordance with Topic 606 as compared to their tax reporting, both from a compliance side as well as financial statement reporting of income taxes in accordance with ASC Topic 740:
A surprising challenge of Topic 606 is the applicable requirements of Subtopic 340-40. Many companies may be caught off guard by the numerous types of compensation arrangements that are scoped into Subtopic 340-40 and require companies to capitalize certain costs.
Companies must thoroughly evaluate compensation agreements, aside from commission arrangements, to determine if any revenue driven bonuses, stock compensation, or fringe benefits will be required to be capitalized. This can also span beyond the standard sales team to include members of management if compensation is structured around revenue.
Additionally, determining the useful life can be a complex exercise, requiring much judgment. This may be especially difficult if there’s minimal historical customer turnover due to the nature of the business.
For more information on how Topic 606 may affect your business, or if you’d like help implementing the standard, contact your Moss Adams professional.
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