Author: Jonathan Hitter, Shareholder
The Financial Accounting Standards Board recently issued new revenue recognition guidance effective December 15, 2017, for public companies and December 15, 2018, for private companies. The new standard will affect all entities that enter into contracts to sell or purchase goods and services.
Not familiar with revenue recognition? An often-misunderstood principle, revenue recognition determines the conditions under which revenue is received. The new standards emphasize that revenue should be recorded when goods and services are transferred, or a customer takes control. Control is identified as the ability to direct the use of and reap the benefits of the goods or services performed under the contract. The guidance provides five steps to implementing the new standards.
Step 1: Identify if you have a contract under the new standard
Not every business uses contracts with their customers. Here are a few questions to determine if you meet the contract tests under the new standards.
- Has the contract been approved and both parties committed either in writing or orally? Is it clear what each party is giving and receiving?
- Does the contract have commercial substance? Meaning, is the exchange of services or goods legitimate?
- Does your contract outline the payment terms? Look at whether you have communicated how much will be exchanged by both parties. Even if an exact price can’t be given, but can be reasonably estimated, that will work.
- Is the work reasonably collectable?
- Lastly, consider the collectability of the contract, have you considered credit risks of your customers?
Steps 2: Identify your performance obligations in the contract.
Next, it’s time to determine who is doing what. That involves identifying the specific goods and/or services that are being delivered to the client. These goods and services each need to be grouped into distinct bundles per the new standards. These bundles must meet a distinction test. The definition of “distinct” being that the customer can use the good or service on its own, without being highly interrelated to other items within the contract.
Step 3: Determine the transaction price
The revised standards have altered how the price is determined. As you estimate your pricing, ask yourself the following questions to determine the transaction price:
- Do offers such as rebates, refunds or discounts alter what you will receive for the exchange?
- Will events, such as weather conditions or market volatility, significantly reduce the amount of consideration?
- Are you receiving payment before or after the delivery? If so, estimates should incorporate this and take into account the time value of money.
- Are you being paid in cash, (includes check or credit card)? If not, the goods or services should be measured at fair value if the customer is not paying cash.
- Do you owe the customer anything aside from the good or service within the contract? If so, this must also be taken into consideration.
Estimates should be looked at regularly and updated after each reporting period to account for any of the variables above.
Step 4: Allocate the transaction price to each bundle.
When including several distinct bundles of goods or services in one contract, recognize the revenue for each separately. Estimate the price as if each of the items was sold to separate customers and ensure its split up and recorded appropriately.
Step 5: Recognize revenue when you satisfy your performance obligation.
Upon transfer of control, or when the customer can use the good or service, revenue is recognized. If the good or service transfers over a period of time, the revenue is recognized over a period of time as well.
With the standard not going into effect until the calendar year 2019, take advantage of this time to decide if the changes will affect your business and speak with one of our accounting professionals now about altering your contracts to ensure a smooth transition when the time comes.