News & Resources

Revenue Recognition Contracts: Part 1

Revenue is the top line of your company's income statement. So, it tends to receive a lot of attention from investors, lenders and other stakeholders. Why? Changes in revenue can tell you whether your company is growing or declining. Moreover, changes in the composition of revenue can provide insight into your strategic plans.
 
The Basics
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, will result in a major shift in the way some companies report revenue. For simple point-of-sale retail transactions, little change is expected: Revenue will continue to be recognized when goods or services are delivered to the customer. The process gets more complicated for long-duration, multi-element contracts, sales that include incentives for customers with poor credit, and contracts with built-in discounts or performance bonuses.

The breadth of change under the new standard depends on your industry. Companies that currently follow industry-specific revenue recognition rules under accounting principles generally accepted in the United States of America (GAAP) will feel the biggest effects from these changes. Examples of the industries affected include software manufacturers, telecommunications companies, defense contractors, airlines, hospitality and gaming companies, and health care providers.

In addition, the companies will now have expanded disclosure requirements, which call for more details on the composition of revenues. (See "Prepare to Add Disclosures," at right.)

Exceptions to the new rules include insurance contracts, leases, financial instruments, guarantees and nonmonetary exchanges between entities in the same line of business to facilitate sales. These transactions remain within the scope of existing industry-specific GAAP.

The Five Steps to Recognizing Revenue

Compared to current practice, the updated guidance requires management to make more judgment calls based on overriding principles. The new standard calls for five steps to decide how and when to recognize revenue:
  1. Identify a contract with a customer.
  2. Identify the contract's "performance obligations" (discrete promises to transfer goods or services).
  3. Determine the transaction price.
  4. Allocate the transaction price to each performance obligation in the contract.
  5. Recognize revenue when or as the company satisfies each performance obligation.
Essentially, the updated standard requires companies to assign a transaction price to each of a contract's separate performance obligations and consider whether it's "probable" they will not have to make a significant reversal of revenue in the future. They also may need to adjust transaction prices to reflect the time value of money. Different companies may interpret the "probable" threshold differently, however, threatening financial statement comparability among entities.

It is important to note that the new standard does not change the total amount of revenue your company reports. Rather it is a matter of timing. Companies may report revenue sooner (or later) under the new standard, depending on the terms of their contracts and management's application of the "probable" threshold.

Use of Estimates
Recognizing revenue under the new standard will require management to make subjective judgment calls on such issues as:
  • Identifying performance obligations,
  • Estimating standalone transaction prices for distinct goods and services, and
  • Evaluating variable consideration (such as rebates, discounts, bonuses and rights to return) when determining the transaction price.
As the start date approaches, it is important to assess whether the use of estimates could expose your company to additional financial reporting risks. Companies are encouraged to conduct a risk assessment to ensure that they meet their financial reporting responsibilities under the new standard. The implementation process may include adopting new internal controls to help prevent management bias and inadvertent errors that could mislead stakeholders about contract revenue.

In light of the increased risk of potential misstatements, during your annual audit expect your auditor to request more documentation and perform different auditing procedures than in previous years. Also, understand that the new rule may result in temporary book-to-tax reporting differences. That is because the tax rules regarding revenue recognition have not yet changed to jibe with the new accounting standard.

The Next Step

If your company issues comparative financial statements under GAAP, you should begin to consider starting the process for adopting the new revenue recognition standard. Most companies that have already made the changes report that it takes more time and effort than they initially expected.