By now, you likely know that there is a new revenue recognition standard that will soon be effective. And you’ve probably heard warnings of the “many implications,” “changing business model,” or “full transformation” that will be required in order to be compliant in time.
So what are the basics that you need to know about the standard? Let’s take a look at them, starting with step No. 1 of its five-step process.
1. Determine whether you have a contract. (Translation: Do we have a deal?)
So after several conversations, presentations, and meetings, you’ve finally closed the deal you’ve been working tirelessly on. Great job! But do you have a contract under the new standard? Here are some specifics to look for when identifying a contract under the new standard:
- A contract is approved and the parties have committed (written or oral).
- A contract identifies the rights of the parties. It’s clear what each party is giving and/or receiving.
- A contract has payment terms. How much or what is being exchanged for the goods and/or services being supplied? If the specific amount is not included in the contracts, but can easily be estimated, that works, too.
- A contract has commercial substance. This means that the exchange is actually worth something. (This provision was mainly implemented to prevent companies from loaning customers money to buy goods or services in order to inflate earnings.)
- Under a contract, collectability is probable. Are you going to get your money? Consider details such as the credit risks of your customers.
2. Identify the performance obligations. (Translation: Who’s doing what?)
Now that you have a contract, it’s time to identify what exactly you are delivering to the customer—goods, services, or both.
Under the new standard, you’ll need to specify each performance obligation into distinct pieces or bundles. In short, the rule says that if a customer can use or benefit from an individual good or service on its own, or with other readily available resources, that it is considered distinct. But if a good or service is dependent on, or highly interrelated with, other items promised in the contract, that piece alone cannot be considered distinct.
Think of this way: If you buy a table from IKEA, you expect them to provide you with the wood panels, screws, bolts, and other pieces required to make the table. If you were only given wood panels on the day of sale, the contract would not be fulfilled, as you cannot do anything with just the wood panels alone. It would not make sense for each of parts to be separate performance obligations. In this case, the bundle of goods makes up one distinct performance obligation.
3. Determine the transaction price. (Translation: What do you expect to be owed?)
The new standard provides several things to consider when determining transaction price:
- Variable consideration. (Translation: Will certain events or offers alter the price you’ll collect?) You need to estimate what you will actually receive in exchange for this contract, taking into account such factors as discounts, rebates, refunds, and other, similar items. Historical and forecast data should also be considered when estimating.
- Constraining estimates of variable consideration. (Translation: Could events occur that would significantly reduce the amount of consideration received?) Any such events should be considered when estimating whether some or all of variable consideration should be included in the transaction price. Even things outside of the entity’s control that could have a major impact on the contract (such as weather conditions and market volatility) should be included. After each reporting period, the estimate should be updated based on the most relevant facts.
- Signification financing component. (Translation: Is the customer paying substantially before or after you deliver?) A time value of money impact should be accounted for in the estimate.
- Noncash consideration: If the customer is not paying cash for the goods or services provided, the goods or services should be measured at fair value of what is being received.
- Consideration payable to a customer. (Translation: Do you owe anything to the customer, aside from the good or service, as a result of the contract?) If so, the revenue recognized should be reduced by that amount.
4. Allocate the transaction price. (Translation: Split it up.)
If the contract includes several separate performance obligations, revenue should be recognized as each is completed. Think of it like this: If you were to sell each of those performance obligations to separate customers, what would be the standalone price?
Another thing to consider is discounts. If a discount relates to only one or a few (but not all) specific contract items, then the discount should be allocated to reduce the transaction price of that performance obligation and reduce revenue related to that performance obligation. However, if it was a general discount, then it should be allocated proportionately as revenue is recognized. A similar rule should be followed for variable considerations.
5. Recognize revenue when (or as) performance obligations are satisfied. (Translation: I have earned my money.)
When can you actually recognize your revenue? The standard states that when transfer of control occurs (translation: the customer can use or benefit from the good(s) or service(s) you provided), you can recognize the revenue.
If the entity transfers control of a good or service over time, then revenue should be recognized over time. For example, a one-year cleaning service contract can be recognized over the year, as the customer is receiving benefits throughout the contract period. If a performance obligation is not satisfied over time, then it is complete when the customer obtains control of the promised asset.