The new revenue recognition model is a 5 steps model that guides companies in determining the amount and the timing of when revenues should be recorded. It shifts from the existing risk and reward model to one that emphasizes control. Here are the 5 steps:
- Identify the contract with the customer
- Identify the performance obligation, i.e. the goods and services to be provided to the customer
- Determine the transaction price
- Allocate the contract value to the goods and services to be provided
- Recognize revenues as goods and services are delivered to the customer
Last month’s newsletter provided you some insights on steps 1 and 2 and now, we’ll take a look at steps 3 to 5.
- Determine the transaction price
The transaction price is the amount the entity expects to be entitled to in exchange for its goods and services. Transaction price may include:
- Variable consideration – this could be explicit or implicit and could include bonus, price concessions, refunds, milestone payments, discounts, returns, and rebates. The entity estimates the amount of the consideration it expects to be entitled to and that it is probable that a significant reversal of revenue recognized will not occur.
- Returns or refunds – entity must estimate the amount of returns or refunds and reduce transaction price and record a refund liability.
- Significant financing component – this represents consideration where the entity receives in advance or in deferred payment terms. Advance payment is likened to receiving a loan from the customer and results in recognition of interest expense and increase in transaction price whereas deferred payment is likened to financing the transaction for the customer and results in recognition of interest income and reduction in transaction price. There are several exceptions to reflecting the significant financing component. (1) the customer has discretion in the timing of the transferred goods and services, e.g. gift card sales; (2) payment of the variable consideration is contingent upon an uncertainty that the entity does not control, e.g. milestone payment contingent on regulatory approval; (3) when the difference in timing of payment and performance is not due to financing but for protection to the entity or customer from the other party for not fulfilling its obligations, e.g. construction contracts; (4) when the timing of payment and transfer of goods and services is one year or less.
- Noncash consideration – its fair value should be included in transaction price. If the fair value of the noncash consideration changes after the contract inception, e.g. value of the customer’s stock, do not adjust the transaction price. If the change is other than in the form of the consideration, e.g. entity’s performance or scope modification, then account for it as a variable consideration.
- Fixed cash consideration – this could include upfront nonrefundable fees that the entity would recognize revenue as goods and services are transferred to its customer.
- Consideration payable to customer – it reduces transaction price unless the entity receives distinct goods and services from the customer
- Allocate the contract value to the goods and services to be provided
The entity will use a relative standalone selling price model to allocate the transaction price. It will estimate the standalone selling price for each performance obligation, determine if any discount or variable consideration should be allocated to one or more performance obligations and allocate the transaction price.
- Recognize revenues as goods and services are delivered to the customer
The transaction price allocated to a performance obligation is recognized as revenue when the performance obligation is satisfied, i.e. when the customer has the ability to direct the use of the goods or services and receives substantially all of the remaining benefits.
When is it effective?
Effective date for public entities is the first interim period within annual reporting periods beginning after December 15, 2017, i.e. 2018 for public companies with December 31 year end; nonpublic entities have an additional year. It also allows early adoption as early as 2017 calendar year.