This RubinBrown Focus on Revenue Recognition is the eighth 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.
Additional Accounting Considerations
From time to time, the price and scope of a contract is changed. The new standard gives guidance on how to evaluate contract modifications to determine if they should be accounted for as a new contract or as a change to the existing contract. The standard states that “a contract modification exists when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to a contract.” The standard points to the enforceability of the changes as opposed to a formalized final agreement to determine when a modification has taken place.
When the scope of a contract increases due to the addition of distinct goods and services and the transaction price increases in a way that is reflective of their standalone selling price, the modification should be treated as a new, separate contract. If either of these criteria are not met, the entity is required to reevaluate the contract as of the modification date.
If the remaining goods and services to be transferred to the customer are distinct from those that have already been transferred, the modification should be treated as the termination of the existing contract and the creation of a new combined contract. The consideration allocated to the remaining performance obligation(s) is the sum of unrecognized portion of consideration in the original contract and the consideration promised in the modification.
If the remaining goods and services are not distinct, the impact of the modification on transaction price and progress toward completion is recognized as a cumulative catch-up adjustment to revenue as of the date of the modification. If the remaining goods and services are a combination of distinct and not distinct, judgement should be used to allocate the remaining transaction price between them in a way that is consistent with the overall guidance on modifications.
The standard also addressed the accounting for costs associated with obtaining and fulfilling revenue contracts. Entities are required to capitalize all incremental costs to obtain a contract that they expect to recover. These are costs like sales commissions that would not have been incurred without execution of the contract. Costs to obtain a contract that would have been incurred regardless of whether the contract was ultimately executed are to be expensed as incurred.
Costs to fulfill a contract that are within the scope of other literature, like inventory, pre-production activity and software, are subject to those requirements. Costs not addressed in other topics are to be capitalized if they meet all of the following criteria:
- The costs relate directly to a specifically identifiable contract or anticipated contract,
- The costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future, and
- The costs are expected to be recovered.
These costs include direct labor and materials, allocations of indirect costs that relate directly to the contract activities and other cost that are incurred only because of the contract or are explicitly chargeable to the customer. Most general and administrative costs, cost overruns, and costs related to past performance are to be expensed as incurred.
These costs are to be amortized on a systematic basis that is reflective of the expected transfer of goods and services to the customer. This expected benefit period will vary depending on the type of costs that are capitalized. The determination of the amortization period will require judgement as it could range from a portion of the initial contract term to the expected customer relationship period, depending on the specific facts and circumstances. The standard does include a practical expedient for capitalizable costs to obtain a contract that allows an entity to expense these costs as incurred if the expected amortization period is less than one year.
Contract assets should be assessed for impairment at each reporting period. An impairment exists when the carrying amount exceeds the future expected revenue less remaining direct costs to fulfill the contract. Some indicators of impairment include loss of customer, loss contracts and contract modifications. Impairment losses cannot be reversed.
Accounting for revenue is complex and requires significant judgement. Companies should allow adequate time and resources to working through the five steps for all their contracts. In the next installment, we will review transition approaches, practical expedients and policy elections.
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Revenue Recognition Resource Center