Overview of New Revenue Recognition Standard

​Rödl & Partner Accounting Matters Vol 2017 – 2, published in September 2017

• Summary 
• ​A. Stated objectives of new guidance on revenue recognition
• B. Scope of new guidance regarding contracts with customers
• C. A significant overhaul of the current revenue recognition guidance
• D. The five-step process for implementing the recognition of revenue under the new guidelines
  • Step 1: Identification of the contract with the customer
  • Step 2: Identification of the seller’s separate performance obligations under the contract
  • Step 3: Determination of the transaction price
  • Step 4: Allocation of the transaction price to each separate performance obligation
  • Step 5: Determination of when each performance obligation is satisfied and recognition of revenue
• E. Contract costs
• F. Presentation and disclosures
• G. Effective date and transition measures
• H. Potential effects on tax expense and compliance

This memorandum offers an overview of the new model for revenue recognition introduced by Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606 or ASC 606)

Summary

Revenue is one of the most important measures used by management, shareholders, lenders, analysts, investors, regulators, and other users to evaluate and monitor an entity’s performance and prospects. However, current revenue recognition guidance differs under United States Generally Accepted Accounting Principles (“U.S. GAAP”) and International Financial Reporting Standards (“IFRS”).

The Financial Accounting Standards Board (“FASB”) and the International Accounting Standard Board (“IASB”), converged the standards on revenue recognition. The FASB issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, and the IASB issued IFRS 15 with the same title to create a new, principle-based revenue recognition framework for every revenue-generating entity.

It is the most impactful accounting standard issued by the FASB and IASB in many years. For U.S. GAAP, the new revenue recognition model is codified in FASB Accounting Standards Codification 606 (“Topic 606”). It eliminates the transaction and industry specific revenue recognition guidance under current U.S. GAAP and replaces that guidance with a principles-based approach for determining revenue recognition. Topic 606 has the potential to impact every entity’s day-to-day accounting and, possibly, the way business is executed through contracts with customers.

Topic 606 incorporates the following five-step process before an entity can recognize revenue.

1. Identify the contract
2. Identify the contract's separate performance obligations
3. Determine the transaction price
4. Allocate the transaction price to the separate performance obligations
5. Recognize revenue as the entity satisfies a performance obligation (transfer control to customer)

Non-public entities are required to apply the new guidance under Topic 606 in annual periods beginning after December 15, 2018 (therefore December 31, 2019 for entities with a calendar year-end), and in interim periods beginning after December 15, 2019. All entities may early adopt the new guidance, but not before annual reporting periods beginning after December 15, 2016.

The remainder of this communication is a detail discussion of the key features included in Topic 606 and provides practical insights into its application and impact.

If you have any questions and or require assistance with the implementation of this new accounting standard related to revenue recognition, please contact your Rödl & Partner office.

A. Stated objectives of new guidance on revenue recognition

• Eliminate the flaws and inconsistencies under the prior rules for revenue recognition;
• Create a single comprehensive framework for entities to apply to recognize revenue;
• Standardize the revenue recognition practices followed across entities, industries, jurisdictions, and capital markets;
• Improve the usefulness of required financial statement disclosures; and
• Make financial statements easier to prepare by providing the rules on revenue recognition in one standard.

B. Scope of the new guidance regarding contracts with customers

• ​Lease contracts covered by Topic 840, Leases;
• Insurance contracts covered by Topic 944, Financial Services-Insurance;

• Contractual rights and obligations covered by any of the following Topics:
  • Topic 310, Receivables;
  • Topic 320, Investments-Debt and Equity Securities;
  • Topic 323, Investments-Equity Method and Joint Ventures;
  • Topic 325, Investments-Other;
  • Topic 405, Liabilities;
  • Topic 470, Debt;
  • Topic 815, Derivatives and Hedging;
  • Topic 825, Financial Instruments; and
  • Topic 860, Transfers and Servicing:
  • Guarantees (except for product warranties or service warranties) covered by Topic 460, Guarantees; and
  • Nonmonetary exchanges that entities in the same line of business enter into for the purpose of facilitating sales to customers (or possible customers).

At times, a contract with a customer may fall, in part, under the scope of Topic 606 and, in part, under the scope of other guidance in the Codification. If so, then an entity must separate the contract into its relevant components and account for each component as appropriate.

Topic 606 only applies to contracts with customers. Therefore, it is important for an entity to understand the definition of a customer. Topic 606 defines a customer as a party that has entered into a contract with an entity for the purpose of acquiring goods or services that are an output of the entity's ordinary activities in exchange for consideration. A collaborator or a business partner is not considered a customer. For example, if two entities form a contract to create a new product and both entities share in the risks and benefits of the new product development, the entities are considered business partners and the contract is not within the scope of Topic 606.

C. A significant overhaul of the current revenue recognition guidance

Many stakeholders view the changes associated with Topic 606 regarding how entities account for revenue from contracts with customer as consequential.

Topic 606 not only supersedes or significantly amends almost all of the current guidance provided in Topic 605, but it also affects significantly other subtopics that relate to revenue. For instance, it adds a new Subtopic 340-40, Other Assets and Deferred Costs-Contracts with Customers.

Finally, Topic 606 amends the existing guidance related to the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with customers to make it consistent with the new guidance on revenue recognition.

• Property, plant, and equipment within the scope of ASC 360, Property, Plant, and Equipment; and
• Intangible assets within the scope of ASC 350, Intangible Assets-Goodwill and Other.

D. The five-step process for implementing the recognition of revenue under the new guidelines

• Revenue should be recognized in a way that reflects the transfer of promised goods or services to customers; and
• The amount of revenue recognized should be equal to the consideration that the entity expects to be entitled to for those promised goods or services.
  

Topic 606 lays out a five-step approach for recognizing and measuring revenue. The five steps are:

Step 1 - Identify the contract

• ​It is between two or more parties;
• It creates enforceable rights and obligations;

• It is in one of the following forms:
  • A written arrangement;
  • A verbal arrangement; or
  • An arrangement implied by the entity's ordinary practices when conducting business.

• The contract has been approved by the parties to the contract;
• Each party's rights can be identified in the contract;
• The payment terms can be identified in the contract;
• The contract has commercial substance; and
• It is probable that the entity will collect the consideration from the customer for the goods and services promised in the contract.

• The entity and its customer negotiate the contracts as a package with the same commercial objective;
• The amount of consideration that the entity will receive under one contract depends on its performance under the other contract or the price of the other contract; or
• The goods or services in the separate contracts are considered a single performance obligation.

If the terms of an existing contract are changed at a later date, an entity is required to assess if the contract modification must be accounted for as a new contract or as an amendment of the existing contract. A contract modification may be a change to the scope of the contract, the price of the contract, or both. The nature of the contract modification (among other items) affects the accounting treatment. Topic 606 provides specific rules for dealing with contract modifications.

Step 2 - Identify the contract‘s separate performance obligations

• A distinct good;
• A distinct service;
• A distinct bundle of goods and services; or
• A series of distinct goods or services that are basically the same and provided to the customer in the same pattern.

An entity generally must account for each performance obligation separately.
A promised good or service is distinct if it meets the following two conditions:

1. The good or service provides a benefit to the customer either by itself or with additional resources that are readily available to the customer; and
2. The good or service can be separately identified from the entity's other promises in the contract.

• The good or service is not an input used to create the end product promised to the customer in the contract;
• The good or service does not substantially change or customize another good or service promised in the contract;
• The good or service is neither highly dependent on nor highly interrelated with another good or service promised in the contract.
  

At times, an entity may promise to provide more than one good or service under a contract. If one of the goods or services promised under the contract is not distinct, the entity must bundle that good or service with other goods or services until the entity identifies a group of items that is distinct.

As part of applying step 2, an entity also must consider whether it serves as a principal or an agent for the transfer of the good or service to the customer.

• Is the entity primarily responsible for completing the contract?
• Does the entity have inventory risk?
• Does the entity have leeway in setting the price for the goods or services?
• Is the entity paid in the form of a commission?
• Is the entity exposed to customer credit risk for the amount receivable for the goods or services?

If an entity is a principal, the entity recognizes revenue for the gross amount that it is entitled to for providing the goods or services. Alternatively, if the entity serves as an agent, the entity recognizes revenue for the amount of any fee or commission that it receives; the fee or commission may be a net amount that the entity retains after it receives consideration from the customer and pays another party for providing the goods or services to the customer.

Step 3 – Determine the transaction price

The third step to recognizing revenue is to determine the transaction price. An entity must determine the transaction price based on the terms of the contract and the entity's customary business practices. The transaction price is calculated as follows:

An entity must use its judgment to determine the amount of consideration to which it is entitled. Even if an entity has received money from a customer, the entity is not necessarily allowed to keep those funds. For instance, a retailer may provide its customer with a right to return a purchased good. If the customer returns the good, the retailer must provide the customer with a refund. In this situation, the retailer must make an estimate of expected refunds in order to estimate the amount of consideration that the retailer expects to be entitled.

As another example, a customer may make a prepayment to an entity for goods or services to be provided in the future. The customer, however, may not exercise all of its rights under the contract. As a result, the entity may be required to return a portion of the funds to the customer (or remit certain funds to another party, such as a government entity that handles unclaimed property).

• Variable or contingent consideration (including any constraints on variable consideration);
• Noncash consideration;
• Consideration payable to the customer; and
• Any significant financing component in the contract (the time value of money).

An entity does not consider the customer's credit risk when determining the transaction price. An entity, however, does consider credit risk when it evaluates whether it will be able to recover the amount of a receivable, contract asset, or asset recognized for contract costs.

Topic 606 provides a constraint on the amount of variable consideration that an entity is allowed to recognize as revenue. Variable consideration involves a degree of uncertainty. This uncertainty could result in an entity ultimately recording less revenue on a contract than it currently expects. Therefore, an entity can recognize variable consideration as revenue only to the extent that the entity thinks it is probable that the entity will not have to record a significant reversal of revenue in the future. An entity must consider whether a significant reversal would be required to the cumulative amount of revenue recognized.

Step 4 - Allocate the transaction price to the separate performance obligations

The fourth step to recognizing revenue is to allocate the transaction price to the separate performance obligations in a contract.

If a contract has only one performance obligation, the transaction price is allocated entirely to that one performance obligation. If a contract has multiple performance obligations, an entity must determine an appropriate allocation of the transaction price to those multiple performance obligations.

The goal of the allocation is to attribute an amount to each performance obligation that represents the amount of consideration that the entity expects to be entitled to for fulfilling that performance obligation.

• Determine the standalone selling price of the good or service associated with each performance obligation; and
• Allocate the transaction price to the various performance obligations based on their relative standalone selling prices.

 
Topic 606 defines the standalone selling price as the price that an entity would sell a good or service to a customer if the good or service was being sold on its own. The standalone selling price generally should be based on the observable price at which an entity sells the good or service separately to similar customers under similar circumstances. An entity, however, may determine that it is appropriate to base the standalone selling price of a good or service on a contractually stated price or list price.

• An adjusted market assessment approach;
• An expected cost plus a margin approach; or
• A residual approach.

The transaction price may change after the inception of a contract. An entity must allocate the change to the separate performance obligations in the contract on the same basis that was used to perform the initial allocation of the transaction price. It is possible that, at the time of this subsequent allocation, one or more of the separate performance obligations will have already been satisfied. If a performance obligation has already been satisfied, the subsequent amount allocated to that performance obligation must be recorded as revenue (or a reduction of revenue) in the period that the change in transaction price occurs.

In addition, in practice, entities sometimes give a volume discount to a customer for purchasing a bundle of goods or services. If an entity provides such a discount, the standalone selling prices of each good or service will exceed the transaction price. Topic 606 generally requires an entity to allocate that discount across the performance obligations based on their relative standalone selling prices.

Step 5 - Recognize revenue as the entity satisfies a performance obligation (transfer control to customer)

The fifth step for recognizing revenue is to record the revenue as the entity satisfies a performance obligation.

• Over time; or
• At a point in time.

• Direct the use of the item; and
• Obtain basically all of the remaining benefits (i.e., potential cash flows) from the item.

Certain types of arrangements or contract terms may pose challenges to an entity in determining when a customer obtains control over a promised good or service.

• Contracts that provide the customer with a right to return the transferred good;
• Contracts that include a warranty;
• Consignment arrangements;
• Bill-and-hold arrangements;
• Contracts that provide the customer with a license; and
• Contracts with a repurchase feature (i.e., a provision under which the entity may be allowed or required to repurchase the transferred good at either its own discretion or the customer's).

Topic 606 provides implementation guidance to assist entities in evaluating these types of arrangements or contract terms.

Under current guidance, an entity may recognize revenue when the entity transfers the risks and rewards associated with the goods or services to a customer. The timing of revenue recognition under the new guidelines is when control of the goods or services under the contract in question transfers to the client.

E. Contract costs

Topic 606 adds a new ASC 340-40, Other Assets and Deferred Costs-Contracts with Customers, to provide guidance on whether an entity must capitalize or expense contract costs. Contract costs include both the costs of fulfilling a contract and the incremental costs of acquiring a contract.

Topic 606 generally requires an entity to capitalize (record an asset for) the incremental costs that the entity incurs to acquire a contract if the entity expects to recover these costs. As a practical expedient, however, an entity may choose to record these costs as an expense as incurred if the asset that would have been recorded would have had an amortization period of a year or less.

• The costs are directly related to the contract;
• The costs create or improve the resources that the entity will use in the future to satisfy performance obligations; and
• The entity expects to recover the costs.

An entity must expense certain costs incurred to fulfill a contract, such as general and administrative costs and the costs of wasted materials, among others.

If an entity capitalizes the costs of fulfilling a contract or the incremental costs of acquiring a contract, the entity must amortize the asset recorded. The entity must amortize the asset in a systematic manner. In addition, the amortization method used must reflect the pattern in which the promised goods or services in the contract are transferred to the customer. An entity also must recognize an impairment loss, as necessary, related to the asset.

F. Presentation and disclosures

Topic 606 requires an entity to present a contract liability, a contract asset, or a receivable in its financial statements once either party to the contract has performed. The entity or its customer may perform under the contract by transferring a promised good or service or making a payment. Whether an entity presents a contract liability, a contract asset, or a receivable depends on the facts and circumstances. For instance, if a customer makes a payment before the entity transfers the promised good or service to the customer, the entity must present a contract liability on its balance sheet.

Topic 606 requires an entity to provide various disclosures about the revenue and cash flows arising from contracts with customers. The objective of the disclosures is to provide users of financial statements with enough information to understand the nature, amount, timing, and uncertainty of those revenue and cash amounts. In general, Topic 606 requires an entity to provide qualitative and quantitative disclosures about the following:

1. The entity's contracts with customers (including information about the related revenue, performance obligations, contract assets, contract liabilities, receivables, and impairment losses);
2. The significant judgments that the entity used in accounting for those contracts (including any changes to those judgments); and
3. Any assets recorded from the capitalization of contract costs (including information about any related amortization or impairment losses).

Topic 606 provides these specific disclosure requirements. Topic 606 provides certain relief to nonpublic entities by allowing these entities to elect not to apply certain of the disclosure requirements. In addition, for all entities, the interim disclosure requirements are less extensive than the annual disclosure requirements.

Topic 606 provides certain specific disclosures that must be applied by all entities. For instance, it requires various disclosures about an entity's performance obligations and its judgments in applying the standard, among other items.

Topic 606, however, largely uses a principles-based approach for disclosures. In other words, it establishes certain overall objectives that must be met by the disclosures but, for the most part, Topic 606 leaves it up to an entity to determine what specific disclosures are necessary to meet the objectives. An entity should not interpret the lack of prescriptive disclosure requirements as an indication that fewer disclosures are required under Topic 606 than under previous guidelines. On the contrary, an entity likely will have to provide more disclosures in order to explain in sufficient detail how it has applied the general approach for recognizing and measuring revenue under Topic 606 to its own facts and circumstances.

G. Effective date and transition measures

While not every entity will experience a significant change in the top line revenue amount, it is likely that Topic 606 once effective will impact every entity. Accordingly, implementation efforts should begin as soon as possible to identify needed changes to systems, processes, and policies.

Effective date

For a nonpublic entity, Topic 606 is effective for annual reporting periods beginning after December 15, 2018, and interim within the annual periods that begin after December 15, 2019. A nonpublic entity may adopt the new guidance early, but it must use one of the following transition date alternatives:

1. An annual reporting period and the interim reporting periods within this annual period that begin after December 15, 2016;
2. An annual reporting period that begins after December 15, 2016 and the interim periods within annual periods that begin one year after the entity initially adopts the new guidance.

Transition measures

Topic 606 provides two alternative transition methods that an entity may elect to apply the new guidance:

1. A retrospective approach that provides an entity with certain optional practical expedients; or
2. A retrospective approach under which the cumulative effect of adopting the standard is recognized at the date of initial application.

In determining which transition method to elect, an entity is urged to consider not only which method is easier to apply but also what the expectations are of the investor community. For example, if a large number of entities (or the key players) in a particular industry indicate that they plan to apply a specific approach, investors may expect for other entities in the industry to follow suit. Therefore, in addition to considering which transition method is most practical to apply, an entity is encouraged to be mindful of the transition methods being chosen by its industry peers.

H. Potential effect on tax expense and compliance

Companies required to change their method of revenue recognition for financial statement purposes will need to consider the effect of the change for income tax return filings and tax accounting.

Change in Accounting Method for Tax Purposes

For income tax purposes, once a business has established an accounting method, that method must be followed on all subsequent income tax returns unless permission has been granted by the Internal Revenue Service (“IRS”) to change the method of accounting. Some accounting method changes are automatically approved by the IRS with filing Form 3115 with the income tax return by the due date or extended due date of the income tax return, while other changes require advance permission from the IRS. Each year, the IRS releases a revenue procedure to guide taxpayers into which accounting changes are automatic and which require advanced consent. Generally, changing from an approved method of accounting to another approved method of accounting has historically been under automatic change provisions. The IRS has asked for comments from taxpayers and practitioners in how to implement the new revenue standard for income tax purposes, and until the IRS compiles and digests all comments into a new guidance, the traditional revenue procedures for changing accounting methods will have to be followed.

Because any change in each business’s revenue recognition methods will be a facts and circumstances determination, the effect on that business’s tax accounting method will also be a facts and circumstances determination. It is possible that a business required to change their method of accounting for financial statement purposes will not fall under the automatic change provisions for income tax purposes, and advance permission may be required if the business wants to follow the new revenue recognition policy treatment for income tax return purposes. Should a business choose to continue the prior method of recognizing revenues for tax purposes, the income tax return will now have a book–to-tax (“M-1”) adjustment that was not previously reflected on the income tax return, resulting in the business having to continue accounting for revenues under both the old revenue recognition standard and the new revenue recognition standard in order to compute the M-1 adjustment.

Change for Tax Accounting

If a business receives permission from the IRS to follow the financial statement treatment for recognizing revenue, whether automatically or with advance consent, no changes will be reflected on the financial statements regarding the tax effect of the change.

If a business chooses to continue filing income tax returns under the old standard for revenue recognition, the M-1 adjustment will result in a deferred tax asset or liability on the balance sheet to reflect the timing differences related to the revenue recognized. The income tax footnote disclosure may have to explain the difference, depending on the materiality of the deferred item.

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