This RubinBrown Focus on Revenue Recognition is the fourth in a series of articles on the new accounting guidance for revenue recognition. In this series, we will explore different aspects of the new standard. Please contact a member of your RubinBrown team for more information and ways that we may be able to help you.
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:
- Identify the contract with the customer.
- Identify the performance obligations within the contract.
- Determine the overall transaction price of the contract.
- Allocate the transaction price between the identified performance obligations.
- Recognize revenue as performance obligations are satisfied.
In the previous article, we provided an overview of the key considerations in identifying performance obligations. Some of the components of this step require significant judgement and have posed some challenges during implementation. This article will highlight some of these areas.
Step 2 – Additional Considerations
Stand-ready obligations – A new concept in the revised revenue standard, a stand-ready obligation is the promise that the customer will have access to a good or service, as opposed to a promise that the entity will transfer the underlying good or service itself. In a stand-ready obligation, the customer’s usage does not, in itself, affect the remaining goods or services to which the customer is entitled. In broad terms, if the promise is to provide a known amount of goods or set number of services, the promise is to deliver the underlying goods and services. On the other hand, the nature of the promise is to stand ready when the number of goods and services to be delivered is unspecified.
Series provision – In certain circumstances, a bundle of goods and services that an entity has determined to be distinct may still be treated as a single performance obligation if they meet the series criteria. A bundle of goods and services is a series if they are substantially the same and have the same pattern of transfer to the customer. The goods or services need not be consecutively delivered to meet the series criteria. In other words, gaps or an overlap in the pattern of transfer to the customer do not impact whether or not there is a series.
In evaluating whether the distinct goods or services are substantially the same, determining the nature of the promises is key. A series can be either specified quantities or tasks to be delivered or a distinct increment of time. Generally, when the promise is to deliver the underlying goods and services, the series evaluation will depend upon whether the goods and services themselves are substantially the same. In contrast, when the promise is to stand-ready to perform, the time increment should be evaluated to determine whether each period is distinct.
The same pattern of transfer means that each distinct good or service in the bundle meets the criteria to be treated as a performance obligation satisfied over time and would have the same measure of progress toward satisfaction of the performance obligation. This determination is especially important in contracts with variable consideration, expected modifications or changes in the transaction price.
Options that provide material rights – Any options included in a contract to purchase additional goods or services will need to be evaluated to determine whether the option provides a material right to the customer regardless of their materiality within the context of the contract. Options that provide a material right are performance obligations while those that do not are considered a marketing offer. To the extent that the option represents an incremental discount that the customer would not have received without entering in the contract, it is considered to be a performance obligation in the form of a promise that the customer is paying for as part of the current transaction. However, the offer is considered to be only a marketing offer if the discount is within a range that is typically given for the specific goods and services to a similar class of customers in the same geographic area.
This determination will often require significant judgement in a number of areas, some of which include determining whether a discount is incremental and distinguishing between an option to purchase and a contract with variable consideration based on variable quantities. A key distinction in this determination lies in the nature of an entity’s obligations under the contract. In an arrangement with a variable quantity that gives rise to variability in consideration, the entity is obligated to perform at the inception of the contract. Conversely, a contract where the entity has no obligation until the customer exercises the option in a separate purchasing decision would generally include an option to purchase. An example of variable quantity would be a service agreement where the entity is obligated to perform an unknown instances of a service and the consideration varies with the number of instances. The customer is not making a separate buying decision for each instance. Compare this to a contract with a fixed number of items and an option to buy additional units. The entity is not obligated to deliver any of the additional units at contract inception. Any orders above the fixed quantity represent a separate purchasing decision by the customer.
This may be an area where those responsible for revenue accounting will need to enhance their communications with marketing, sales and operations department to ensure that all offers that are made to customers can evaluated in light of the guidance.
Warranty – The new standard defines two types of warranties. An assurance-type warranty promises that the deliverables will function as intended. A service-type warranty promises additional services in addition to the assurance warranty. If the customer has the option to purchase the warranty separately or if the warranty provides for more than fixing defects that existed at the time of the sale, it is a service-type warranty. The standard provides guidance to assist in making this determination, giving the following factors to consider:
- Whether the warranty is required by law – In this circumstance, the warranty is not a performance obligation.
- The length of the warranty period – The longer the coverage period, the more likely that the warranty is a service-type.
- The nature of the promised tasks – Tasks necessary to provide assurance are not likely to be a performance obligation. If there is a practice of providing incremental services outside of the stated warranty free of charge, it is important to consider whether or not these give rise to an implied performance obligation.
Overall, the accounting for warranties is similar to legacy GAAP. Assurance-type warranties are not separate performance obligations and an estimate of the obligation should be accrued at the time of the sale. As a separate performance obligation, service-type warranties should be allocated a portion of the transaction price based on relative standalone selling prices and should be recognized in a pattern consistent with the way the obligation is satisfied.
Gross versus net presentation – Principal versus agent considerations continue to be an area of complexity, particularly in service transactions, including instances like digital advertising where there are multiple parties involved and the transactions take place instantaneously. While the guidance is similar to legacy GAAP, the new standard focuses on control as the determining factor. Control is defined as the ability to direct the use of and obtain substantially all of the remaining benefit from an asset. The standard provides a list of control indicators (606-10-25-25). These are not meant to be a checklist, as different indicators can be more or less relevant in different circumstances. In this regard, it is important to note that in the new standard transfer of legal title is one indicator among many and is no longer a decisive factor in and of itself. Also, note that the use of judgment does not imply that the standard permits optionality.
Pre-production activities – This is a potential area of change from legacy GAAP. Entities that previously considered pre-production activities as part of the revenue process need to carefully consider whether these meet the definition of performance obligations. Generally, this determination will hinge on whether control passes to the customer and certain activities that were considered part of the revenue process previously will not meet the new criteria. Additionally, if you have previously excluded these activities from revenue, a change would be unlikely.
Shipping and handling activities – Shipping and handling activities performed prior to the transfer of control are fulfillment activities and not separate performance obligations. For any activities that are performed after control passes, the standard includes a practical expedient that allows entities to account for these as fulfillment activities. While the standard does provide guidance on the revenue side, it does not address the classification of the related expenses. Generally, the determination made under legacy GAAP for these costs would remain unchanged.
Licenses of intellectual property – The new standard provides a separate model for recognizing revenue generated from licensing agreements. The key determination is whether the license is for functional or symbolic intellectual property (IP). Functional IP has significant standalone functionality and generally has no support or maintenance obligations that represent an additional good or service. These would include things like software, a film or music and a patented formula or process. Symbolic IP derives its utility from the past and ongoing development and support of the property, like a brand or trade name. This determination can be complex, and incorrect identification of the type of IP will lead to incorrect timing of revenue recognition as it will impact the measure of progress applied in Step 5.
Step 2 is one of the more complex, judgmental areas of implementation and is also critical to determining the correct accounting. Touching base with your accountants or auditors at this point is certainly a best practice to ensure you are aligned on the conclusions reached thus far.
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