On May 28, 2014, the Financial Accounting Standards Board (FASB) issued accounting standards update on revenue recognition, Revenue from Contracts with Customers (Topic 606). The guidance in the revenue recognition standard update affects entities that enter into contracts with customers to provide goods or services and or certain nonfinancial assets. Specifically, the update focuses on contracts in which the entity promises more than one distinct good or service to the customer.
The new standard, which is a significant change to the accounting rules for revenue recognition, became effective for years beginning after December 15, 2017 for public entities and conduit debt obligors, such as not-for-profit organizations that have issued bonds. All other entities are required to apply the new revenue recognition standard for years beginning after December 15, 2018.
The FASB recognizes that revenue presented in financial statements is an important measure in evaluating an entity’s financial performance. The change came about because the previous revenue recognition guidance in Generally Accepted Accounting Principles (GAAP) was too broad and had revenue requirements for certain industries and or transactions, which sometimes resulted in different accounting for transactions that were economically similar.
The objectives of the new revenue standard are summarized by the FASB as follows1:
1. Remove inconsistencies and weaknesses in revenue requirements.
2. Provide a more robust framework for addressing revenue issues.
3. Improve comparability of revenue recognition practices across entities, industries, jurisdiction, and capital markets.
4. Provide more useful information to users of financial statements through improved disclosure requirements.
5. Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.
The guidance does not apply to certain contracts that are within the scope of other standards. An example of contracts within the scope of other standards are lease and insurance contracts. It is important to note that the new revenue recognition standard update also supersedes some of the guidance included in revenue recognition for construction and production type contracts.
The following are the steps an entity should apply to achieve the core principle of the new standard:
As noted in the chart above, after identifying the contractual performance obligation, the transaction price must be allocated to the distinct performance obligations in the contract. The FASB provides the following guidance to allocate the appropriate amount of consideration to each distinct performance obligation:
“To allocate an appropriate amount of consideration to each performance obligation, an entity must determine the standalone selling price at contract inception of the distinct goods or services underlying each performance obligation and would typically allocate the transaction price on a relative standalone selling price basis.”2
Note: Distinct performance obligations are accounted for separately.
Additionally, the new standard is more conservative compared to the prior revenue recognition standard. As an example, the new standard requires the entity to evaluate the probability of collection upon the transfer of goods and or services to the customer. If it is probable that a material reversal will occur, the revenue for the questionable amount should not be recognized until
the uncertainty associated with this variable transaction is resolved. Also, if there is an existence of a material financing component and the timing of the payments per the contract extend over a year, the entity is required to adjust the promised consideration for the effects of the time-value of money.
In summary, the new revenue recognition standard, when compared to previously existing guidance, significantly improves the comparability of revenue recognition across entities and industries, addresses revenue recognitions issues upon delivery of the good and service, and, in general, can be applied to contracts with customers regardless of industry or transaction-specific factors.
See link below to the standard, as it contains additional provisions, not addressed in this summary, which entities should be aware of to ensure the proper application of Revenue from Contracts with Customers (Topic 606).