This RubinBrown Focus on Revenue Recognition is the seventh 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.
Step 5 – Recognize Revenue
Now that the performance obligations have been identified and the transaction price has been allocated between them, Step 5 determines when revenue is recognized. The standard’s fundamental principal is that revenue is to be recognized as performance obligations are satisfied by the entity’s transfer of the promised goods or services to the customer. A good or service is transferred when the customer obtains control which can occur in two ways: at a point in time or over time.
Control is defined as the ability to direct the use of and obtain substantially all of the remaining benefits from the goods and services. While this concept is similar to that of legacy GAAP, there are differences. Under the new standard, the FASB asserts that control should be assessed primarily from the customer’s point of view and provides indicators to assist entities in evaluating when control passes.
At contract inception, each performance obligation must be evaluated to determine if it is satisfied over time or at a point in time. A single performance obligation can only be satisfied in one way. When the performance obligation is satisfied at a point in time, revenue is recognized when control transfers to the customer. For over time, revenue is recognized in a manner that is reflective of the entity’s performance and transfer of control.
A performance obligation is satisfied over time if any of the following criteria are met:
- Customer simultaneously receives and consumes the benefits provided by performance as the entity performs; (e.g., payroll processing service)
- Performance creates or enhances an asset that the customer controls as the asset is being created or enhanced; (e.g., construction of fixed assets at customer location) or
- Performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date (e.g., construction of a highly customized asset with right to payment, including reasonable profit margin, as work is performed).
For performance obligations satisfied over time, entities will select a single measure of progress that is reflective of the entity’s performance. The standard allows for both input and output methods, leaving it to the entity to determine the most appropriate measure. The measure to be used is selected at contract inception and cannot be changed during the course of the contract. Additionally, the same measure should be used for similar contracts in similar circumstances. The estimate of progress is to be updated at each reporting date.
If the conditions listed above are not met, the performance obligation is satisfied at a point in time and revenue is recognized when control passes to the customer. Indicators of when control passes include:
- The entity has a present right to payment for the asset;
- The customer has legal title to the asset;
- The entity has transferred physical possession of the asset;
- The customer has the significant risks and rewards of ownership of the asset; or
- The customer has accepted the asset.
No single indicator is meant to be individually determinative, nor is this list meant to be a checklist with each having equal weight. An entity is to consider all facts and circumstances to determine when control passes. In many cases, the conclusion here will mirror that reached under legacy GAAP. Title and risk of loss are no longer the primary considerations, but do represent factors that are often present when a customer has control. The standard also indicates that a customer’s right of return is a factor in determining the transaction price not in transfer of control. For most entities, the accounting for returns will not change.
In some cases, a performance obligation might include a license of IP and one or more other promised good or service. In these circumstances, an entity must consider the nature of the combined good or service when determining whether the overall promise is satisfied over time or at a point in time. The same is true for selecting an appropriate method for measuring progress of performance obligations satisfied over time.
Step 5 also requires an entity to consider a number of contract provisions that could impact the transfer of control. These include:
- Customer acceptance,
- Repurchase provisions,
- Certain options,
- Consignment arrangements, and
- Bill and hold agreements.
If an entity can objectively determine that the goods or services have been transferred to the customer in accordance with the agreed-upon specifications in the contract, then customer acceptance is a formality that would not affect the entity’s determination of when the customer has obtained control. Judgement will be required to assess the impact of these provisions on the timing of revenue recognition.
The new standard impacts all entities. While some entities may not have significant changes to their accounting for revenue, every entity will need to assess their revenue transactions in light of the new standard to ensure all facts and circumstances have been adequately considered. In the next installment, we will discuss the final accounting considerations of the new standard, contract modifications and contract costs.
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Revenue Recognition Resource Center