On May 28, 2014, the Financial Accounting Standards Board ("FASB") issued its standard on revenue recognition, No. 2014-09, "Revenue from Contracts with Customers". The new standard will ultimately affect all industries, some more significantly than others, by establishing a single comprehensive model that will eventually exist in the FASB's Accounting Standard Codification Topic 606. The standard, among other things, is expected to remove inconsistencies in current revenue requirements, improve comparability across entities and industries and provide more useful information to users of financial statements.
The core principle of the revenue recognition standard is that an entity should recognize revenue from the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those good or services. Revenue from a transaction or event that does not arise from a contract with a customer (whether written, oral, or implied by an entity's customary business practices) would not be within the scope of this standard. Management must evaluate its contracts in full to identify all the relevant parties, as it is possible that portions of certain contracts are within the scope of this new guidance and portions are not, such as collaboration agreements.
The new standard's core principles require that management perform the following steps:
- Identify the contract with the customer.
- Identify the performance obligation in the contract.
- Determine the transaction price.
- Allocate the transaction price to performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies the performance obligations.
Perhaps the biggest change for companies operating in certain industries is to identify the separate performance obligations in a contract. A performance obligation is a promise to transfer a distinct good or service or a series of distinct goods or services over time that are substantially the same. Revenue will be recognized when a company satisfies a performance obligation by transferring a promised good or service to a customer, which is when the customer obtains control of that good or service.
The increased emphasis on a broad principles-based approach will lead to a greater reliance on professional judgment and on actual contract terms and conditions. It is anticipated that attorneys and other professional advisors will play an increasingly proactive role, drafting agreements to clearly define when and how an entity transfers the control of goods or services. The key to revenue recognition under the new standard is the transfer of "control," not the transfer of risks and rewards, which is often analyzed under current guidance.
Under the new guidance, determining the transaction price becomes a more nuanced exercise, potentially changing the timing of recognition by providing management with the ability to utilize the "probable" threshold to determine the expected value of the contract. This variable consideration, which is to be evaluated each reporting period, includes consideration of items such as performance bonuses, penalties, refund rights and volume discounts.
When evaluating contracts it is important to note that the standard, as a practical expedient, allows a company to aggregate contracts or performance obligations with similar characteristics if the entity reasonably expects that the effects on the financial statements would not be materially different if analyzed and accounted for separately.
As noted above, one of the main objectives of this revamping of the standards is to provide more useful information to users of financial statements. This is partially accomplished through increased disclosure requirements, and it is important for management to review and understand these new requirements. Although the new standard may not lead to material changes in a company's results of operations, the new disclosures are likely to require additional management judgment and analysis. The increased reliance on judgment will also require increased documentation by management to support its assessments.
Public entities are required to adopt the revenue recognition standard for reporting periods beginning after December 15, 2016, and for all interim and annual reporting periods thereafter. Early adoption is not permitted.
Although the standard is not effective until periods beginning after December 15, 2016, management should begin evaluating the new standard to determine its ramifications. The standard allows for either a full retrospective approach for all periods presented or a modified approach, which can lead to significant calculations depending on a company's contracts. Enhanced disclosures will be required, including information about performance obligations and any transaction price allocations, significant judgments (and changes in judgment) each reporting period that effect the transition price, and assets recognized from the cost to obtain or fulfill a contract.
It is important for management to understand the effects of the new standard and proactively plan for an efficient and successful implementation. Although not all entitles will be significantly impacted by this standard, all entities should expect changes in the measurement and timing of revenue and identify any required changes to policies, procedures, disclosures and internal controls, to guarantee that revenue transactions are appropriately evaluated and reported.
Audit committee members should be included in discussions with management to determine the best method of implementation and its effect on financial reporting. With companies currently evaluating their existing internal control environment as a result of the new 2013 COSO framework (see SEC Impact Volume 6, Issue 2 and Volume 5, Issue 12), this is a good time to consider how this standard will affect processes related to revenue recognition and the respective disclosures.
If you have any questions about the content of this article, please contact Justin Van Fleet at JVanFleet@FriedmanLLP.com.