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Focus on Revenue Recognition: Step 1

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First, consider whether the contract is with a customer. A customer is defined as “a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.”

February 21, 2018

The core principle of the new standard is to recognize revenue from customers in a way that reflects the entity’s transfer of promised goods and services at an amount that represents the consideration that the entity expects to receive in exchange for those goods and services. The new revenue recognition model uses five steps to achieve this principle:

  1. Identify the contract with the customer.
  2. Identify the performance obligations within the contract.
  3. Determine the overall transaction price of the contract.
  4. Allocate the transaction price between the identified performance obligations.
  5. Recognize revenue as performance obligations are satisfied.

Step 1

First, consider whether the contract is with a customer. A customer is defined as “a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.”

The standard applies to contracts with customers that are not leases, insurance contracts or financial instruments. If the contract includes revenue components in addition to one or more of these out of scope components, each component should be accounted for under the respective guidance.

Once you have determined that you have an agreement with a customer that is in scope, next consideration is whether or not you have a contract with a customer.

A contract is defined as “an agreement between two or more parties that creates enforceable rights and obligations” and meets ALL of the following five criteria:

  • The contract has been approved by the parties and each is committed to perform their respective obligations
  • Each party’s rights regarding the promised goods or services are identifiable
  • Payment terms for the promised goods or services are identifiable
  • The contract has commercial substance
  • Ultimate collections of the consideration is probable

A contract can be written, oral or according to customary business practices. You can have an agreement without a contract. For example, if an agreement lays out terms and conditions, but does not specify a transaction or require performance, it doesn’t meet the definition of a contract under the standard as there is no commitment to perform.

Be aware that termination penalties, repurchase provisions or put options can cause the contract to be out of scope or can impact the contract term.

The standard is meant to be applied at the individual contract level. However, as a practical expedient, an entity may apply a portfolio approach to a group of contracts with similar characteristics if there is a reasonable expectation that results of applying the guidance to individual contracts would not be materially different from using the portfolio approach. Additionally, the standard requires an entity to consider contracts with the same counterparty that are entered into at or near the same time. These contracts should be combined and evaluated together if any of the following criteria are present:

  • The contracts are negotiated as a single commercial objective
  • The amount of consideration paid in one contract is dependent on the price or performance of the other contract(s)
  • The goods and services promised in the contracts are a single performance obligation

Contract Modifications

A contract modification is a change in the scope or price of a contract that either creates new or changes existing enforceable rights and obligations of the parties to the contract. Modifications must be carefully evaluated to determine the appropriate treatment under the new rules. Depending on the terms or the revised agreement, modifications may be treated as a completely separate contract or as a change to an existing contract. Changes resulting from those that are deemed to be a modification of an existing contract can be treated on a prospective basis or may require a cumulative catch-up adjustment in the period of modification.

Final Thoughts

We don’t anticipate many entities will have trouble identifying contracts. However, the rules for combining contracts and analyzing contract modifications can be difficult in certain circumstances.

 

Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.

Revenue Recognition Resource Center

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