Revenue Recognition 5 Steps Model – steps 3 to 5

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:

  1. Identify the contract with the customer
  2. Identify the performance obligation, i.e. the goods and services to be provided to the customer
  3. Determine the transaction price
  4. Allocate the contract value to the goods and services to be provided
  5. 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.

  1. 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
  1. 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.

  1. 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.

Revenue Recognition 5 Steps Model – Steps 1 and 2

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:

  1. Identify the contract with the customer
  2. Identify the performance obligation, i.e. the goods and services to be provided to the customer
  3. Determine the transaction price
  4. Allocate the contract value to the goods and services to be provided
  5. Recognize revenues as goods and services are delivered to the customer

In this month’s newsletter, we’ll take a look at the first two steps and then steps 3 to 5 next month.

  1. Identify the contract with the customer

A contract is defined as an agreement between two or more parties that create legally enforceable rights and obligations. It can be written, oral or implied based on customary business practices. If a contract provides for each party to terminate the agreement without penalty, then there is no accounting consequences related to the contract since there is not a legally enforceable right and obligation to the parties. However, just because there are legally enforceable rights and obligations, it doesn’t mean that you are in the clear. There are still some criteria that need to be evaluated to determine whether a contract exists.

  1. Does the contract have commercial substance?
  2. Have approvals been obtained and commitment to perform exist for both parties?
  3. Are rights of both parties are identifiable?
  4. Are payment terms identifiable? And
  5. Is collection probable?

Once these criteria are met, reassessment is not necessary unless signification changes in circumstances occur.

What if an entity goes through step 1 and determines that a contract does not exist? In this situation, any considerations received should be recognized as a liability and the entity should reassess the criteria each reporting period. If the criteria continue not to be met, the entity can only recognize revenues when the considerations received are nonrefundable and

  1. There are no remaining performance obligations and substantially all amounts have been received.
  2. The contract has been terminated. Or
  3. The entity has transferred the control of goods and services to which the nonrefundable considerations relate and the entity has no future obligation to transfer additional goods and services.

The last criterion differs from current guidance in that it allows for recognition of revenue in the amount related to the goods and services transferred even though the entity continues to perform under the contract.

Contract modifications – The guidance on contract modifications is new in comparison with existing guidance, except in contract accounting. The accounting for contract modifications allows for prospective treatment, a cumulative catch up adjustment or account for as a separate contract, depending on facts and circumstances. Some of the issues to consider include whether the changes are approved; the pricings of the modifications; any distinct new products or services added, etc.

  1. Identify the performance obligation, i.e. the goods and services to be provided to the customer

The overall objective of step 2 is to identify the units of account to which the entity will then apply steps 3 to 5 to. The entity will identify all of the promised goods and services, considering both explicit and implicit promises, based on customary business practices.

Next, the entity needs to consider whether the identified goods and services are distinct. If so, they are accounted for separately as a performance obligation, i.e. unit of account. Otherwise, the entity should combine other goods and services until there is a group that is distinct. The guidance does provide an exception that when goods or services are part of a series of distinct goods or services that are substantially the same, the series of goods or services is the performance obligation. A good example of this is television/cable services – the customers typically are locked into a contract and each hour of the service provided is distinct. However, since each hour of the service is substantially the same and is delivered in the same manner, they are counted as one performance obligation.

Since distinctiveness is a key factor, how does an entity determine whether a good or service is distinct? A good or service is capable of being distinct when a customer can benefit from it on its own or together from other readily available resources. For example, an entity sells equipment to its customers. The customers can sell the equipment on a standalone basis. The customers can use the equipment together with other goods or services that have already been transferred by the entity, i.e. installation service for equipment purchased by the customers; or installation services from other providers in the marketplace.

The entity should also consider whether warranty is a distinct performance obligation. If the customer has the option to purchase the warranty separately, then the warranty is a performance obligation. Otherwise, the entity should allocate part of the purchase price to the warranty and recognize revenues over time.

In addition, if the customer has the option to purchase additional goods and services, the option is a performance obligation for accounting purposes if it provides material right to the customers that the customers would not otherwise have without entering into the contract.

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.

Revenue Recognition Standard (Topic 606)

Revenue Recognition Standard (Topic 606)

What is it all about?

The new revenue recognition standard applies to contracts with customers except for those within the scope of other standards, e.g. leases, insurance, etc. The new standard eliminates the lack of consistency in revenue recognition across industries. Therefore, it improves comparability and eliminating gaps in guidance.

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:

  1. Identify the contract with the customer
  2. Identify the performance obligation, i.e. the goods and services to be provided to the customer
  3. Determine the transaction price
  4. Allocate the contract value to the goods and services to be provided
  5. Recognize revenues as goods and services are delivered to the customer

The new revenue recognition standard also requires a lot of quantitative, as well as qualitative, information to be disclosed.

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.

How is it done?

Companies can select one of the two adoption methods – full retrospective or modified retrospective.

Full retrospective – this requires recasting prior years’ revenues as if the standard has existed from the beginning, i.e. the years shown prior to 2018. This method provides great comparability from period to period which is appealing to investors and analysts and other users of the financial statements but requires more efforts and resources for dual reporting.

Modified retrospective – no recasting is required but companies need to record the cumulative effects of the adoption to beginning retained earnings at the time of adoption. This may seem easier than the full retrospective approach but it also requires more disclosures to improve comparability in a different way.

Why should companies care?

Assessment – Companies should perform assessments to evaluate what kind of an impact this standard will have on their financial statements, if any.  Since the new standard’s issuance in 2014, companies that began their assessments reported that the process of assessment was taking longer than they thought. Even companies that didn’t believe that this new standard applied to them still should carry out such assessment to document that it has no impact on them. A lot of these companies found that once they began assessing the impact, the new standard actually have material impacts to them than originally thought.

Implementation – Significant amount of work that needs to be done during the implementation process in order to adopt the standard. Some companies discovered that they will need to change their processes and systems in order to be able to capture the data needed. Some discovered that they will need to involve personnel outside of accounting, e.g. operations, IT, sales, etc. in understanding their contracts with their customers. Some may decide that they will need to create sub-ledger in order to capture the data in their accounting systems.

Reporting – Much like the new lease accounting standard we discussed in our blog in May, this new revenue recognition standard could also have significant impact on certain financial covenants.

Although the 5 steps model may seem easy, the devil is in the details!! We can help you go through the model step by step and identify provisions that really matter when it comes to revenue recognition. Contact us at:

E-mail: Stella@cfoconnections.com

Phone: 813-508-5846