Revenue Recognition: the Basics

In May of 2014, a new set of revenue recognition standards were released by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). These two bodies worked together to publish codified guidelines for how companies should report the revenues they earn from contracts with customers. The new standards are known by two names: Accounting Standards Codification 606, and International Financial Reporting Standards 15 – or, more simply, ASC 606 and IFRS 15. The FASB’s final version of the new standards, ASC 606, varies slightly from the IASB’s version, IFRS 15, but the overall impact will be the same – companies in all types of industries will have to modify their internal processes in order to comply.  The standards take effect for non-public companies for fiscal years beginning after December 15, 2017.

The Five-Step Model

The bulk of the new revenue recognition standards can be outlined in what’s known as the five-step model. To recognize revenue from contracts with customers, organizations must take the following five actions with each contract that they draft:

1. Identify the contract with the customer.
2. Identify the separate performance obligations.
3. Determine the transaction price.
4. Allocate the transaction price.
5. Recognize revenue when (or as) the performance obligations are satisfied.

To fully understand this model, let’s dig a bit deeper.

Identify the contract with the customer

Before you do anything else, you must first determine if you have a legitimate contract with your customer. A contract is a legally binding agreement between two parties to provide goods or services in exchange for some form of payment. Under ASC 606, an agreement with a customer will be considered a contract if all of the following are true:

• Both parties have agreed, in writing or orally, to the terms.
• The contract identifies the rights and obligations of both parties.
• The agreement outlines what is being exchanged and explains the payment terms.
• The contract has commercial substance. In other words, the contract must be fair and reasonable.
• The performance of duties and collectability of payment are probable.

Identify the separate performance obligations.

The contract should clearly identify who is doing what, and in what order. One contract may include multiple distinct obligations that, if combined, are necessary to complete the transfer of the goods or service. Each performance obligation must stand alone to be considered a separate and distinct obligation from the others listed in the contract.

Determine the transaction price.

The contract should list what you expect to be paid for the goods or service you provide. Will you be paid a fixed amount when you deliver the goods to the customer? Will your invoices vary depending on the time spent on the project? Both fixed and variable consideration is acceptable, but the terms must be clear.

Allocate the transaction price.

You should allocate the final price of the contract to each performance obligation that you determined in Step 2. If there is only one performance obligation, this allocation process is simple – 100% will be allocated to that one activity. However, if you have multiple performance obligations, you must determine how the payment should be divided up between tasks.

Recognize revenue when (or as) the performance obligations are satisfied.

As you complete the performance obligations, you should recognize revenue according to how you allocated the transaction price in Step 4.

Disclosures

Public companies are required under the new revenue recognition standards to include both qualitative and quantitative disclosures in their financial statement footnotes about their revenue recognition practices. Because FASB thought this would be unduly burdensome on private companies, non-public entities are exempted from most of these disclosure requirements. They are, however, required to disclose the following:

• Revenue broken out based on the timing of when the goods or services are transferred. For example, they should separate revenues that were earned over time from revenues that were earned at one certain point in time.
• Beginning and ending balances of contract assets and liabilities. These are new accounts created under the new standard.
• Details about their performance obligations, including when the entity satisfies their obligations, significant payment terms, and how warranties and returns will be handled.
• The assumptions they made or methods they used to estimate variable consideration, which is a consideration that may depend on certain variables in order to be received.

Contact Us

Because these new standards will require buy-in from almost every level in the organization, companies are choosing to implement new internal controls to support their compliance goals. These internal controls can take different forms, and you can choose the controls that will work best with your industry and your specific organization. If you would like to discuss how to implement these changes or would like to discuss the new standard in more detail, Wilson Lewis can help! For additional information please call us at 770-476-1004 or click here to contact us directly. We look forward to speaking with you soon.