This RubinBrown Focus on Revenue Recognition is the ninth 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.
Transition Methods & Practical Expedients
The new standard allows for two methods of adoption: full retrospective and modified retrospective. In the full retrospective method, the transition date is the first day of the first comparative period presented in the financial statements for the year of adoption. When using the full retrospective method, entities have a number of practical expedients available to reduce the complexity of implementation including:
- An entity need not restate contracts that begin and are completed within the same annual reporting period.
- An entity may use hindsight to establish a variable component of the transaction price at the date the contract was completed rather than estimating variable consideration in the comparative reporting periods.
- For contract modifications prior to the transition date, an entity can simply consider the modified contracts as of that date when i) identifying the satisfied and unsatisfied performance obligations; ii) determining the transaction price and iii) allocating the transaction price to the satisfied and unsatisfied performance obligations.
There is also some relief from disclosures required for the comparable periods.
When using the modified retrospective approach, an entity has the option to account for all contracts or only those open at the transition date. The contract modification practical expedient described above is also available under the modified approach.
Practical Expedients and Policy Elections
The standard also includes a number of additional practical expedients and policy elections.
Portfolio approach practical expedient
An entity may apply the standard to a portfolio of contracts or performance obligations with similar characteristics if the entity reasonably expects that the effects on the financial statements of applying this guidance to the portfolio would not differ materially from applying this guidance to the individual contracts or performance obligations within that portfolio. When accounting for a portfolio, an entity should use estimates and assumptions that reflect the size and composition of the portfolio. An entity is not required to perform a quantitative assessment of all scenarios to determine that the outcomes are similar. Rather, an entity should take a reasonable approach and use estimates and assumptions that reflect the size and composition of the population.
Right-to-invoice practical expedient
If an entity has a right to consideration from a customer in an amount that corresponds directly with the value to the customer of the entity’s performance completed to date (for example, a service contract in which an entity bills a fixed amount for each hour of service provided), the entity may recognize revenue in the amount to which the entity has a right to invoice. This, in essence, relieves the entity from Step 3 and 4. However, in many instances, it may be difficult to establish that direct relationship. Specifically, features like upfront payments, retroactive price adjustments, and fixed billing schedules may impact an entities ability to utilize this practical expedient.
Significant financing component
An entity can make a policy election not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less.
Shipping and handling activities
To the extent that shipping and handling activities are performed prior to the transfer of control, they represent fulfillment activities and do not constitute a separate promised service. If the activities occur after the transfer of control, an entity can make a policy election to treat them as fulfillment activities and not be required to evaluate whether they are separate promised services to its customers. The entity should apply this accounting policy election consistently to similar types of transactions. If revenue is recognized for the related good before the shipping and handling activities occur, the related costs of those shipping and handling activities shall be accrued.
Sales tax (amounts collected on behalf of third parties)
An entity may make an accounting policy election to exclude all taxes assessed by a governmental authority from the transaction price provided that the tax is imposed on a specific revenue-producing transaction and collected by the entity from a customer (for example, sales, use, value added, and some excise taxes).
Incremental costs of obtaining a contract may be recognized as an expense when incurred if the amortization period of the asset would have been one year or less.
Implementation of the new standard is complex and requires significant judgement, but there are a number of options available with a goal of reducing the level of effort. In the next installment, we will discuss internal controls and disclosure requirements.
Readers should not act upon information presented without individual professional consultation.
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