At this point, everyone in the accounting world has likely heard about the FASB’s new revenue recognition standard, and the effective date for implementation by public companies has already arrived. Private companies that haven’t yet assessed the impact that the new standard will have on their accounting and financial reporting practices shouldn’t delay their analysis any longer.
The new revenue recognition standard is likely to significantly impact the revenue recognition practices of most companies that utilize GAAP as their basis of accounting. The new accounting requirements standardize how entities in all types of industries recognize revenue from customer contracts. This new standard takes a principles-based approach, with the goal of eliminating inconsistencies that have resulted from previously existing industry specific guidance or lack of guidance relevant to certain types of arrangements.
The new revenue recognition standard allows organizations to use some degree of judgement when recording revenue so that their financial statements reflect the true economic realities of their businesses. The new standard became effective for public companies on January 1, 2018, and is effective for all other organizations in 2019.
The Five-Step Model
The new accounting standard begins and ends with the five-step model to evaluate agreements with customers and determine the timing of revenue recognition:
Step 1: Identify the customer contract.
A contract is a legally-binding agreement, whether implied or explicit, between two parties that exchange goods or services. The agreement must also meet the following criteria:
1. Both parties must agree to the contract terms.
2. The contract must identify the parties’ rights and responsibilities.
3. The payment terms must be clear.
4. The contract must have commercial substance.
5. It must be probable that both parties will fulfill the responsibilities stipulated in the contract.
Step 2: Identify the performance obligations in the contract.
The unit of account for revenue recognition under the new standards is a performance obligation. Performance obligations, or “deliverables,” are distinct promises written into the contract to perform a specific service or provide particular goods to the customer. The contract may consist of one or more unique performance obligations.
Step 3: Determine the transaction price.
The cost of the contract and the payment terms should be plainly stated.
Step 4: Allocate the transaction price to the performance obligations.
Determine how the transaction price is allocated to each performance obligation. Estimates are acceptable as long as the rationale for determining estimates is disclosed.
Step 5: Recognize revenue when (or as) the performance obligations are satisfied.
As the goods or services provider satisfies the separate and distinct performance obligations that were identified in Step 2, revenue associated with each performance obligation should be recognized, as determined in Step 4.
Principles, rather than rules, are what drive this new accounting standard. Organizations may find this freedom helpful, but users of the financial statements will demand to know how the organization made their decisions and assumptions. This is where well-written, clear and concise disclosures about revenue recognition policies come into play.
In general, most companies will want to disclose the following information.
- Information about contracts.
Users of the financial statements will want to know what types of contracts the business enters into. Disaggregating revenue into meaningful “contract classes” can be a helpful way to disclose this information. Classes may be grouped by geographical region, contract duration, type of service performed, pricing structure, etc.
- Information about contract balances.
The year-end balances of open contracts can give users of the financial statements an idea of what obligations the organization has forthcoming. Detailing what performance obligations remain will be key.
- Information about performance obligations.
The company should share assumptions made and standards used to define specific performance obligations. Disclosures should make it clear how they determine if an obligation has been met and how the contract’s value is allocated to the different performance obligations.
- Information about transaction price.
The entity should explain how the overall transaction price has been determined, including estimates used and how variable consideration is calculated.
For public organizations, the standard became effective for all interim and annual reports for fiscal years that began after December 15, 2017. Private companies were given an additional year to comply. The standard became effective for private entities on their first annual report that began after December 15, 2018. Interim reports should reflect the changes for reporting years that begin after December 15, 2019.
To discuss this new accounting principle or any changes that are affecting your business, please contact us.