Many companies, large and small, offer a broad range of products and services to their customers. Often these product and service sales are negotiated at the same time with a single customer, resulting in a single contractually binding arrangement with multiple deliverables.
Consider the cell phone company that provides a free or discounted phone to a customer who signs up for a two-year contract. A product (the phone) has been delivered at the beginning of the contract with a current cash flow (including activation fees) and a reasonably certain guaranteed future cash flow.
This arrangement presents a challenging revenue recognition question: under accrual accounting, how should revenue be measured and assigned to components of the sale? The fact that the seller provides goods and/or services over a period of time means the seller completes the earnings process over a period of time. Though in theory this may seem simple enough, previous accounting standards had resulted in inconsistent treatment of arrangements with multiple deliverables. The lack of consistency and comparability led to FASB Accounting Standards Update (ASU) 2009-13, released on Oct. 7, 2009.
This update will cause substantial changes to GAAP. New GAAP for multiple-deliverable arrangements will provide a clearer picture of the economic realities of such arrangements. Whether an element has an objective and reliable fair value, as previous GAAP requires for separation, is no longer important. The economic reality is that if the service is being offered to the customer, that element has value and, if appropriate, should be recognized accordingly. In addition, the more robust disclosure requirements will give financial statement users a better picture of how a company is earning its money.
This article presents the major GAAP revisions affecting multiple deliverables along with brief examples of how the changes will affect practice.
The major changes to previous GAAP (laid out in ASC 605-25) will likely lead to most affected companies disclosing more information than before. Because certain GAAP methods will no longer be permitted, and additional disclosures will apply, companies are likely to incur significant learning curve costs. The revenue recognition changes—made through a codification update (2009-13)—are effective prospectively for revenue arrangements entered into or materially modified in fiscal periods beginning on or after June 15, 2010, and earlier application is encouraged. Contracts created before then do not have to apply the new standards, however.
All new financial accounting updates must disclose their impact on standards convergence, but this change is probably only indirectly related to international standards. Befitting its principles basis, IFRS says little about multiple-element arrangements. What it does say in IAS 18, Revenue, indicates a fair value approach to revenue recognition, which is not what FASB is dictating. Nonetheless the boards are working toward common goals, and it is expected that any revision of IAS 18 will not be inconsistent with this new U.S. GAAP. Much of new GAAP is consistent with recent pronouncements from the IASB. In a discussion paper resulting from a joint revenue recognition project, FASB and the IASB have indicated “the transaction price should be allocated to each performance obligation in proportion to the stand-alone selling price of the promised good or service underlying that performance obligation” (IASB Discussion Paper Preliminary Views on Revenue Recognition in Contracts with Customers, December 2008, par. 5.46).
While the new disclosure requirements are more substantial and will require much effort, the valuation change to a relative-selling-price-based approach is perhaps a paradigm shift in accounting for revenue recognition in these situations.
NEW RULES FOR FINANCIAL STATEMENT DISCLOSURES
The changes to previous GAAP will likely have the greatest impact on the level of financial statement disclosure of such arrangements. The greatest change users can expect to see is vastly expanded and improved disclosure of arrangements on which they were offered little information in the past. While significant disclosure about revenue recognition has been required for some time, with specific respect to multiple deliverables it had not been extensive.
GAAP had specified only the two relatively brief disclosures, the accounting policy for recognition of revenue from multiple deliverables and a description of the nature of the arrangements. New GAAP prefaces specific disclosure requirements with a statement about the objective of the disclosure: “The objective of the disclosure guidance in this Section is to provide both qualitative and quantitative information about a vendor’s revenue arrangements and about the significant judgments made about the application of this Subtopic and changes in those judgments or in the application of this Subtopic that may significantly affect the timing or amount of revenue recognition. Therefore, in addition to the required disclosures, a vendor shall also disclose other qualitative and quantitative information as necessary to comply with this objective [Pending Content ASC 605-25-50-1].”
It then proceeds to specify the specific disclosures required:
- The nature of its multiple-deliverable arrangements.
- The significant deliverables within the arrangements.
- The general timing of delivery or performance of service for the deliverables within the arrangements.
- Performance-, cancellation-, termination-, and refund-type provisions.
- A discussion of the significant factors, inputs, assumptions, and methods used to determine selling price (whether vendor-specific objective evidence, third-party evidence, or estimated selling price) for the significant deliverables.
- Whether the significant deliverables in the arrangements qualify as separate units of accounting, and the reasons that they do not qualify as separate units of accounting, if applicable.
- The general timing of revenue recognition for significant units of accounting. [Pending Content ASC 605-25-50-2]
FINANCIAL STATEMENT DISCLOSURES
To observe how companies have been recognizing and disclosing revenue in contracts with multiple deliverables, as well as to see how these disclosures may change as a result of the accounting standards update, we examined a selection of companies to compare revenue recognition disclosures. The companies were chosen because each of them offers contracts containing multiple deliverables. In particular, all of the companies offer service agreements within the same arrangements as the sale of their products. As one example, the following is an excerpt from the Honeywell International Inc. 2008 annual report:
Revenues from contracts with multiple element arrangements are recognized as each element is earned based on the relative fair value of each element provided the delivered elements have value to customers on a standalone basis. Amounts allocated to each element are based on its objectively determined fair value, such as the sales price for the product or service when it is sold separately or competitor prices for similar products or services.
Although this disclosure goes beyond the previous disclosure requirements, several elements will have to change to meet new GAAP disclosure requirements. Most importantly, this note does not describe the nature of these multiple-element arrangements, only that they exist and are recognized separately. Financial statement users can expect to gain a greater understanding of the economics of these arrangements (that is, product sales along with service agreements).
As a second example of recent practice, below is an excerpt from the Verizon Communications Inc. 2008 annual report:
We recognize equipment revenue for services, in which we bundle the equipment with maintenance and monitoring services, when the equipment is installed in accordance with contractual specifications and ready for the customer’s use. The maintenance and monitoring services are recognized monthly over the term of the contract as we provide the services. Long-term contracts are accounted for using the percentage of completion method. We use the completed contract method if we cannot estimate the costs with a reasonable degree of reliability.
As was the case with Honeywell, Verizon’s disclosure contains more than what had been required previously under GAAP. While Verizon does give more of an explanation of the nature of these arrangements than Honeywell’s note did, the above note lacks any mention of how arrangement consideration is allocated to the multiple elements. In this case, Verizon’s note will become substantially more robust with disclosure of how the allocation was made, among many other elements.
One of the most interesting outcomes of ASU 2009-13 will undoubtedly be that many companies will disclose the existence of multiple-element arrangements for the first time. For example, in its 10-Q dated Oct. 31, 2009, Titan Machinery Inc. disclosed the following with regard to ASU 2009-13:
In October 2009, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance on revenue recognition, codified in ASC 605-25, Revenue Recognition. This guidance modifies the fair value requirements of revenue recognition on multiple element arrangements by allowing the use of the “best estimate of selling price” in addition to vendor specific objective evidence and third-party evidence for determining the selling price of a deliverable. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence, (b) third-party evidence, or (c) estimates. In addition, the guidance eliminates the residual method of allocation and significantly expands the disclosure requirements for such arrangements. This guidance is effective for fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company is in the process of determining the impact that this guidance will have on the Company’s consolidated financial statements.
Aside from this disclosure, Titan’s 10-Q made no other mention of multiple-element arrangements. This is not to imply that Titan has not been following GAAP properly. It is meant to illustrate that for many companies more robust disclosure will not be the only outcome of ASU 2009-13. Companies will need to take time to consider the ramifications of the revised standard.
NEW RULES FOR REVENUE RECOGNITION
The second fundamental change in standards due to ASU 2009-13 is the approach to the allocation of revenue to the various elements of a multiple-element arrangement. These elements to which revenue amounts are assigned by GAAP are referred to as separate units of accounting.
To justify the allocation of revenues to a separate unit of accounting, GAAP previously required three criteria to be met. In addition to having demonstrated objective and reliable evidence of the fair value, each separately identifiable deliverable had to have stand-alone value to the customer and, in cases where there was a general right of return, delivery of the undelivered item(s) had to be considered probable and substantially in the control of the vendor [ASC 605-25-25-5].
The first criterion is being eliminated, while the other two remain. It will no longer be necessary for there to be a relative fair value determination for revenue allocation. The estimated fair value approach is being replaced by a sales-based approach called the relative-selling-price method. While this method will replace the fair value method, in situations where vendor-specific objective evidence (VSOE) or third-party objective evidence (TPOE) are available, it will not result in different practice.
The question of how to measure the fair value (and soon, estimated selling price as evidenced in the Pending Content in ASC 605-25-30) assigned to each separate accounting unit is presented in ASC 605-25-30, and much of this previous guidance will be retained under the relative-selling-price method
The initial measurement of each separate unit of accounting is presently based on the relative fair values of each of the deliverables and undelivered items, assuming they are known. That initial measurement will now be based on relative selling price.
The preferred method and the second level preferences remain VSOE and TPOE, and the criteria for what constitutes each have not changed. The GAAP change will replace the term “relative fair value” in the first two criteria with the term “relative selling price.”
Furthermore, eliminating the relative fair value method will result in the elimination of the residual method, which applied if VSOE and TPOE were not available. The residual method allocates the portion of the total arrangement, which is deemed to be fair value of the undelivered items, to those items and assigns the difference to the delivered items.
Under new GAAP, if VSOE and TPOE are not available, managers will use an allocation based on estimated selling prices. The method of determining the estimated selling price in the absence of VSOE and TPOE is expected to conform to the method of determining VSOE; in particular, management will need to estimate the price it would charge for the deliverable if it was regularly sold on a standalone basis. In doing so, management must consider general market conditions as well as factors specific to the entity which could impact the price charged.
SYSTEMS, POLICIES MAY REQUIRE CHANGE
As a result of the changes to GAAP, companies will have to analyze their various sales arrangements to ensure correct accounting and disclosure. This may prove a more difficult task than at first glance. Due to the elimination of the residual method and other finer points of the new standards, accounting systems and policies may have to be reconfigured. Likewise, making the necessary disclosures may prove troublesome if companies wait too long to review their revenue-generating activities.
New GAAP in Action
The following example demonstrates application of the relative-selling-price method. It is based on one of the 12 examples (example 5) found in the implementation guidance at ASC 605-25-55.
Entity S is a home appliance dealer. Entity S sells Appliance W on a standalone basis for $800 and charges $50 for installation (total $850). Most customers elect to pay the $50 because comparable services from an independent provider cost more, estimated at $75. This is the price Entity S would charge if it were to install an appliance bought elsewhere. Assume the necessary conditions for these two elements to be considered separate units of accounting have been met.
Under the relative-selling-price method using vendor-specific objective evidence (VSOE), Appliance W would be valued at its stand-alone price of $800 and using VSOE or third-party objective evidence (TPOE), the value of the installation services is $75, and the estimated total selling price of both elements is $875. The revenue allocation is:
|Appliance W||[$850 x ($800/$875)]|| |
|Installation||[$850 x ($75/$875)]|| |
New GAAP also adds a caveat that whether or not VSOE or TPOE exists, the “vendor shall not ignore information that is reasonably available without undue cost and effort” [Pending Content ASC 605-25-30-2]. This directive was not offered under GAAP when discussing the establishment of fair value.
Both previous and new GAAP indicate that, while stated prices indicated in the contract for multiple deliverables may contain information valid for establishing the relative sales prices, these prices are not presumed to be an indicator of fair value/selling price.
Accounting Standards Update 2009-13, released in October 2009, made significant changes to revenue recognition for multiple-element sales.
Whether an element has an objective and reliable fair value, as previous GAAP required for separation, is no longer important. The economic reality is that if the service is being offered to the customer, that element has value and, if appropriate, should be recognized accordingly.
The elimination of the residual method and other finer points of the new standards may mean that accounting systems and policies will have to be reconfigured. Likewise, making the necessary disclosures may prove tricky if companies wait too long to review their revenue-generating activities.
The revenue recognition changes are effective for fiscal periods beginning on or after June 15, 2010, and earlier application is encouraged. Contracts created before then do not have to apply the new standards, however.
Gerald P. Weinstein (email@example.com) is a professor and chairman of the Department of Accountancy at John Carroll University in Cleveland. Nicholas A. Yacobozzi (firstname.lastname@example.org) is an assurance associate in the Cleveland office of a public accounting firm.
To comment on this article or to suggest an idea for another article, contact Kim Nilsen, editorial director, at email@example.com or 919-402-4048.
National Advanced Accounting and Auditing Technical Symposium, July 15–16, Lake Buena Vista (Orlando), Fla.
Auditing Revenue in Certain Industries–AICPA Audit Guide (#0125110)
For more information or to make a purchase or register, go to cpa2biz.com or call the Institute at 888-777-7077.
Revenue Recognition in Today’s Business Climate (#RTBC)
Go to aicpalearning.org to access courses. Click on “On-Site Training” then search by “Acronym Index.” If you need assistance, please contact a training representative at 800-634-6780 (option 1).
FASB Accounting Standards Update 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements
More from the JofA: