The Revenue Recognition Improvement Initiative was taken up as a joint venture between the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).
As a result of the initiative, the FASB amended its Accounting Standards Codification (ASC) to create the new Topic 606, ”Revenue from Contracts with Customers”, while the IASB by issued IFRS 15, “Revenue from Contracts with Customers”, both of which are virtually identical.
Prior to the convergence, the US Generally Accepted Accounting Principles (GAAP) was comprised of broad revenue recognition concepts with varying revenue requirements for particular industries or transactions, which sometimes resulted in different accounting for similar transactions. Meanwhile, the IFRS provided limited guidance through IAS 11 and IAS 18, its two main revenue recognition standards. All of the existing guidance and standards from both organizations will be replaced with this new standard. Based on discussions and updates released by the Transaction Research Group (TRG), a joint group formed by the FASB and IASB, this standard will become effective at different times for different entities.
a. Public and Certain Not-For-Profit Entities: The annual reporting periods (including interim reporting periods within these periods) begins after December 15, 2017
b. Other Entities: The annual reporting periods (including interim reporting periods within those periods) begins after December 15, 2019
The core principle of the IFRS 15 and ASU 2014-09 – Topic 606 establishes a five-step model for recognizing revenue earned from a contract. The five principles suggested by the new standard are:
By understanding the changes in how entities must now identify the separate performance obligations in a contract, organizations will be better prepared to adapt to this new standard.
What is meant by Performance Obligations?
Performance obligations are the implicit or explicit promises in a contract to transfer goods or services to customer. Under this new guidance, the seller must identify whether the goods or services discussed in the contract are distinct. To make this determination, the selling company should consider:
If the buyer can benefit from the goods or services on its own or combined with other resources that may be readily available to the customer
If the selling company can consider its promise to transfer the goods or services as separately identifiable from other promises in the contract
Whether other incidental obligations and/or sales incentives exist in the contract, what they are and when they will be due to the customer.
A good or service promised in a bundle with other goods or services would not be considered as distinct if two conditions are both met:
The goods or services in the bundle are highly integrated, and the company provides a significant service in integrating them into a combined item
The bundle of goods or services is significantly modified or customized to fulfill the contract with customer
Immaterial promises are to be ignored and not separately accounted.
Why performance obligations are important in the new standard
Correctly determining the amount and timing of revenue to be recognized is required before undertaking the next steps in the revenue recognition process. This may not include every item explicitly mentioned in a contract with a customer. The seller must also identify other components of the goods or services that could be considered essential for transferring the benefits associated with the goods or services specified in the contract, such as their installation or customization.
For both the third step in revenue recognition of determining the transaction price, as well as the fourth step of allocating the transaction price to the performance obligations in the contract, determining the performance obligations of the seller under contract is critical. Analyzing the judgments applied when determining the performance obligations and ensuring consistency in their application when reviewing revenue recognition practices across bundled or individual products and services lines also important.
The new standard will necessitate challenging changes to processes, systems, data, and internal controls for organizations across every industry.
1. Business processes that may require changes: Companies need to assess the implications across their order-to-cash processes and record-to-report procedures to determine if they adequately address the requirements for the performance obligations under the new standard. Policies and procedures for areas such as contract management and calculating standalone selling prices are among a few areas that need to be reassessed.
What are the necessary changes to in determine or Identify Performance Obligations?
2. Dependencies on data will be increased: The new standard will require companies to capture and report on incremental information such as future committed payments, tiered discounts and other data that may be required to determine performance obligations, variable consideration and allocable prices. It will also need a comprehensive understanding of the business scenarios, related use cases, technology, existing data warehouses and their integration in order to accurately analyze and report on this information.
3. Revenue automation solutions will require upgrades and enhancements
Revenue automation solutions can provide analysis of historical sales data to determine standalone selling prices, link related transactions into a single contract and allocate consideration to individual performance obligations.
Companies will need to identify business and system requirements for revenue recognition scenarios and define future state architectures before implementing a revenue automation solution
4. Disclosure requirements may require significant modifications: Companies may need to provide additional disclosures regarding the timing and nature of revenue recognition, disaggregation of revenue, contractual asset and liability balances, contract costs, and the amount of the transaction price allocated to performance obligations not yet satisfied.
5. Revenue allocation should be reconsidered: Companies will need to consider systematic and long-term solutions to identify ways and means of revenue allocation In order to comply with this new standard.
6. Costs to acquire customers will be capitalized: The standard requires certain costs to acquire a new customer such as sales commissions, advertisements and promotions to be capitalized and amortized.
Industry specific implementation considerations:
Existence of Contract: Under the new revenue recognition standard, healthcare companies may need to consider the customer’s ability and intention to pay the amount to which the companies are entitled to in determining if a contract exists, and if revenue can be recognized.
Presentation of Bad Debts: The revenue recognition standard requires adjusting the amount of bad debt expenses presented in operating expenses by the amounts that are determined to be a concession, such as adjusting the transaction price rather than bad debt expense.
2. Travel, Transportation and Logistics:
Customer Loyalty Programs: Credits issued under customer loyalty programs are separate performance obligations if they provide the customer with a material right that the customer would not receive without buying the initial product or service. The transaction price needs to be allocated between the initial purchase and the award credits based on the actual or estimated standalone selling price of each obligation. The portion of the transaction price allocated to the award credits is not recognized as revenue until the credits are redeemed or expire.
Transportation Costs: Costs to fulfill a contract are in the scope of the revenue guidance only if they are not addressed by other standards. An entity should recognize an asset under the revenue guidance for costs to fulfill a contract only if the costs relate directly to a contract, generate or enhance resources of the entity that will be used in satisfying performance obligations in the future, and are expected to be recovered.
Customer Reward Points, Gift Cards, Coupons, and Other Loyalty Programs: Choices that allow customers to acquire supplementary goods or services for free or at a discount would likely represent a separate performance obligation if it gives the customer a material right that it otherwise would not have received without entering into the contract. Retail entities currently deploying a cost accrual model to existing reward programs may need to alter their accounting policies in accordance with the above requirements, essentially resulting in revenue deferral.
Transaction Price Calculations: If the transaction price is subject to changeability, such as dependency on sales incentive, an entity is required to estimate the transaction price using the expected value approach. Companies may need to develop approaches to estimate the transaction price, including the impact of variable amounts, and may also need a process to update these estimates each reporting period.
Right to Return: The new method allows companies to recognize revenue for goods subject to a right to return if it is possible that doing so would not result in a significant revenue reversal.
Licenses: Under the new standard, companies will need to evaluate whether the existing and future licenses and other services such as promotions or advertisements constitute separate performance obligations and distribute revenue accordingly. Companies will need to determine whether the license provides access (over time revenue recognition) or a right to use (point in time revenue recognition). If the license involves a usage-based royalty, then revenue may need to be deferred until the licensee’s succeeding sales or usage occur.
Revenue Allocation: The new standard requires applying judgment to identify all performance obligations in a contract, primarily for software licenses or software as a service (SaaS) engagements where access to software is often bundled with ancillary services such as design, hosting, post-contract customer support and upgrades.
Licenses: Licensing and usage rights may cause a change in the recognition of licensing revenue, as companies will determine if a license is distinct from other performance obligations and, if so, whether the license provides access (recognition over a period) or a right to use (point in time recognition).
- Promises in Contracts with Customers: A contract with a customer generally explicitly states the goods or services that an entity promises to transfer to a customer. However, the performance obligations identified in a contract with a customer may not be limited to the goods or services that are explicitly stated in that contract. This does not include administrative activities performed to set up the contract or any activities that do not entail performance obligation.
- Distinct Goods or Services: To be distinct, a good or service must meet two criteria:
It must be capable of being distinct
It must be separately identifiable or “distinct within the context of the contract”
An entity should consider each promise to deliver a good or service in a contract in light of these two criteria. The first criterion (capable of being distinct) is similar to the notion of standalone value under ASC 605. If a good or service is capable of being distinct, a customer should be able to benefit from the good or service on its own, or in combination with other resources the customer has readily at hand.
The second criterion, however, or the requirement of a good or service being “distinct within the context of the contract,” is a new concept, early interpretation of the guidance has varied. ASC 606 emphasizes that entities should evaluate if promised goods or services represent individual promises or inputs making up a combined output or outputs.
Bundle: A strategy that joins products or services together in order to sell them as a single combined unit. Bundling allows the convenient purchase of several products and/or services from one company.
Immaterial Promise: The term immaterial refers to the general notion of materiality. That is, an entity should consider the relative significance or importance of a particular promised good or service in the contract to the arrangement with the customer as a whole. In applying this notion, an entity should consider both the quantitative and the qualitative nature of the promised goods or services in the contract.