In April 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), with various clarifying amendments since. This ASU applies to organizations that enter into contracts, either written or implied, with customers for the transfer of good and services in exchange for consideration.
Non-public entities are required to adopt the new revenue recognition standards for reporting periods beginning on or after December 15, 2018 (calendar year 2019), and interim and annual reporting periods beginning after December 15, 2019 (calendar year 2020). Although the standard is not required until the calendar 2019 reporting period, it will need to be applied retroactively to prior periods presented in the financial statements. Therefore, if an organization issues comparative financial statements, the revenue recognition standards will be applied to calendar 2018 as well.
The purpose of the ASU is to provide a single principle-based standard that can be applied across various industries rather than the industry specific standards that currently exist. The new standard will also require additional revenue disclosures.
The core principle of Topic 606 is that an organization should recognize revenue in a way that matches when the organization has met each obligation (whether goods or services) under the contract, and the revenue should be recognized at a value commensurate with such obligation. The new revenue recognition standards do not apply to the following types of contracts: lease contracts; insurance contracts; financial instruments; and guarantees.
The revenue recognition standard explains that to achieve the core principle of Topic 606, an organization should follow the five step model as described below:
Step 1: Identify the contract with the customer
A contract is an agreement between two or more parties that creates enforceable rights and obligations. A contact can be written, oral, or implied by an organization’s standard business practices.
There are certain criteria that a contract must meet:
- Contract has been approved by both parties, and both parties are committed
- Each party’s rights regarding goods or services can be identified
- Payment terms can be identified
- Contract has commercial substance
- Collectability of consideration is probable
Step 2: Identify performance obligations
A performance obligation is a promise in a contract with a customer to transfer to the customer either a good or service that is distinct or a series of goods or services that are substantially the same and that have the same pattern of transfer to the customer. Examples of performance obligations include: constructing, manufacturing, or developing an asset on behalf of the customer; granting licenses; and granting options to purchase additional goods or services.
For a good or service to be considered distinct it must meet two criteria:
- The customer can benefit from the good or service either on its own or together with other resources that are readily available
- The organization’s 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 organization expects to receive in exchange for transferring goods or services, excluding amounts collected for third parties (e.g. sales tax).
An organization should consider the following to determine the transaction price:
- Variable consideration
- The existence of a significant financing component
- Non-cash considerations
- Consideration payable to the customer
Step 4: Allocate the transaction price to the performance obligation
The revenue recognition standard states that if a contract has more than one performance obligation, an organization should allocate the transaction price to each separate performance obligation in an amount that depicts the amount of consideration to which the organization expects to be entitled in exchange for satisfying each separate performance obligation.
To allocate an appropriate amount of consideration to each performance obligation, an organization should determine the stand-alone selling price at contract inception of the distinct goods or services underlying each performance obligation. Sometimes, the transaction price includes a discount or variable consideration that relates entirely to one of the performance obligations in a contract. The requirements specify when an organization should allocate the discount or variable consideration to one (or some) performance obligation(s) rather than to all performance obligations in the contract.
An organization should allocate to the performance obligations in the contract any subsequent changes in the transaction price on the same basis as at contract inception. Amounts allocated to a satisfied performance obligation should be recognized as revenue, or as a reduction of revenue, in the period in which the transaction price changes.
Step 5: Recognize Revenue When (or as) the Performance Obligations are Satisfied
Revenue should be recognized as performance when a performance obligation is satisfied by transferring of the good or service.
For each performance obligation, an organization would determine whether the organization satisfies the performance obligation over time by transferring control of a promised good or service over time. If the organization does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.