If your company hasn’t yet begun implementing the changes to revenue recognition, now is the time to start.
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, which introduced Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers. ASC Topic 606 supersedes long-standing, industry-specific guidelines and fundamentally changes how companies across nearly every industry should recognize revenue.
While some companies have adopted ASC Topic 606 prior to the recent issuance of ASU 2020-05, which deferred the effective date, others have yet to implement the new accounting standard. Here are four considerations for your entity as it begins its revenue-recognition implementation efforts.
ASC Topic 606 was the result of the FASB’s joint project with the International Accounting Standards Board (IASB) to improve the financial reporting of revenue. Legacy Generally Accepted Accounting Principles (GAAP) is composed of broad revenue recognition concepts and detailed guidance for particular industries, which often resulted in different accounting for similar transactions.
The purpose of the new revenue recognition standard is to eliminate inconsistencies in how businesses across industries account for similar revenue transactions by providing a comprehensive revenue recognition model that applies to a wide range of industries.
1. Review the Revisions
Using a new five-step accounting process, ASC Topic 606 establishes comparability within financial reporting across industries by applying a uniform framework to revenue recognition. Much of legacy GAAP is built around a risks-and-rewards notion, where revenue is recognized when substantially all of the risk of loss from the sale of goods or services has passed to the customer. In contrast, the trigger for revenue recognition under ASC Topic 606 is based on the transfer of control of a good or service to the customer.
The basic principle within ASC Topic 606 is that a company should recognize revenue when it transfers goods or services to a customer in an amount in which it expects to be entitled to receive from the customer. The new five-step revenue accounting process is as follows:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when—or as—the entity satisfies a performance obligation
The new model may lead to different revenue recognition patterns and amounts, as compared to legacy GAAP. This means that companies must analyze their contracts and apply significant judgment to determine when the control of goods or services has occurred and to determine the amount they’re expected to be entitled to receive in return.
2. Analyze Your Agreements
While there are some narrow scope exceptions, generally, all revenue streams should be assessed under the new standard.
Companies need to perform a thorough analysis of all contracts with customers. A contract with a customer is in the scope of ASC Topic 606 if all of the following conditions are met:
- Commitments. The parties have approved the contract—in writing, orally, or in accordance with other customary business practices—and are committed to performing their respective obligations.
- Rights. Each party’s rights, regarding the goods or services to be transferred, can be identified.
- Commercial substance. The arrangement has commercial substance, meaning the risk, timing, or amount of the company’s future cash flows is expected to change as a result of the contract.
- Probability of collectability. The payment terms are identifiable and it’s probable the seller will collect substantially all of the consideration to which it’s entitled.
If an agreement meets the above criteria, the contract should be evaluated under the ASC Topic 606 five-step process to determine the timing and amount of revenue recognition.
3. Apply the Five-Step Process
To achieve the core principle of the new revenue standard, contracts with customers within the scope of ASC Topic 606 must be assessed under the following five-step process.
- Identify the contract with a customer. A contract is an agreement between two or more parties that creates enforceable rights and obligations. Under the new revenue standard, a contract with a customer is any agreement that adheres to the ASC Topic 606 contract criteria, as detailed above.
- Identify the performance obligations in the contract. A performance obligation is a promise—explicit or implicit—to transfer to a customer a distinct good or service, or a series of distinct goods or services, that are substantially the same. A contract may include multiple promises, such as the sale of goods produced by the company, shipping and handling activities, marketing incentives, or the service of arranging for another party to transfer goods or services to the customer. Companies must assess each promise to determine whether it’s distinct and represents a separate performance obligation.
- Determine the transaction price. The transaction price is the amount of consideration an entity expects to be entitled to in exchange for transferring the promised goods or services. When calculating the transaction price, a company is required to consider both fixed consideration and variable consideration, such as potential discounts, rights of return, liquidated damages and performance bonuses. The amount of variable consideration included in the transaction price should be calculated using either the best estimate or expected value approach.
- Allocate the transaction price to the performance obligations in the contract. If a contract contains only one performance obligation, allocating the transaction price is a relatively simple calculation. However, if a contract contains multiple performance obligations, an entity must allocate the transaction price to each performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying that particular promised good or service.
- Recognize revenue. An entity recognizes revenue when—or as—the entity satisfies a performance obligation by transferring control of the goods or services to the customer.
To learn more about how to apply each of these five steps, see our Revenue Recognition Guide.
4. Disclose Revenue
Along with the amended accounting guidance, ASC Topic 606 requires additional revenue disclosures, both qualitative and quantitative. The objective of the added disclosures is to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. To learn more about the additional revenue disclosures, read our article.
While nonpublic companies may elect not to provide certain disclosures, they’re still required to disclose information about contracts with customers—including disaggregation of revenue, contracts balances, and performance obligations—and the significant judgements made in applying the guidance within ASC Topic 606. Nonpublic companies must also disclose information regarding their accounting policies and the transition method and related effects of adoption.
As a result, many companies will likely need to update their accounting policies and will find their revenue recognition disclosures greatly expanded as compared to previous guidance.
If your company hasn’t yet begun implementing ASC Topic 606, it will need to act quickly to meet all accounting, presentation, and disclosure requirements.
The amendments in ASU 2020-05 defer the required effective date of ASC Topic 606 for one year for certain entities that haven’t yet issued their financial statements—or made financial statements available for issuance—reflecting the adoption of ASC Topic 606.
Those entities may elect one of the following options:
- Adopt the guidance for annual reporting periods beginning after December 15, 2019, and for interim reporting periods within annual reporting periods beginning after December 15, 2020.
- Follow the original effective date of annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019.
We’re Here to Help
To learn more about the new revenue recognition standard or how it may impact your company, read our Revenue Recognition Guide or contact your Moss Adams professional.