In Part 1 of this series, an overview of the new Accounting Standards Update (ASU) No. 2014-09 Revenue from Contracts with Customers was provided. The standard will apply to public, private and not-for-profit organizations that enter into contracts with customers to transfer goods or services. For some entities this may result in a major shift in the way they recognize revenue.
The new revenue recognition standard uses five steps to achieve this principle:
1. Identify the contract with the customer.
2. Identify the performance obligations in the contract.
3. Determine the overall transaction price of the contract.
4. Allocate the transaction price between the identified performance obligations.
5. Recognize revenue as performance obligations are satisfied.
In this article we dive deeper into Step 1. Identify the contract with a customer and Step 2. Identify the separate performance obligations in the contract to provide more information on how to apply these steps.
Step 1. Identify the contract with a customer
The following criteria must be met in order to account for a contract with a customer under the revenue recognition standard:
- The parties to the contract have approved the contract. The contract can be in writing, orally or in accordance with customary business practices and the parties must be committed to perform their respective obligations.
- The entity can identify each party’s rights for the goods or services that will be transferred.
- The entity can identify the payment terms for the goods or services that will be transferred.
- The contract has commercial substance.
- It is probable that all or substantially all of the consideration will be collected from the customer for the goods and services promised in the contract. The entity will assess collectability of the consideration for goods or services that will be transferred to the customer rather than all of the goods and services promised in a contract.
Although the word contract may suggest a document, the agreement does not have to be in writing but could be a verbal arrangement or an arrangement implied by an entity’s customary business practice between two or more parties. A contract must also create enforceable rights and obligations. If a party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party then a contract does not exist.
If consideration is received from the customer but the contract does not meet the criteria to be considered a contract then the entity should recognize the consideration as revenue only when one or more of the following events occurs:
- The contract is terminated and the consideration is nonrefundable,
- There is no further obligation to the customer, all (or substantially all) of the consideration has been received from the customer, and the consideration is nonrefundable; or
- Control of the goods or services related to the consideration has been transferred, transferring goods or services has been stopped, there is no further obligation to transfer more goods or services, and the consideration is nonrefundable.
A liability would be recognized for the consideration received until one of the above events occurs or until the contract meets the criteria to be considered a contract.
At times, an entity may enter into one or more contract for the sale of related goods and services or a single contract for the sale of unrelated goods and services with the same customer. The contracts should be combined and accounted for as a single contract if one or more of the following criteria are met:
- The contracts are entered into at or near the same time.
- The contracts are negotiated as a package with a single commercial objective.
- The amount of consideration that will be paid per one contract is dependent on the performance or price of the other contract.
- The goods or services in the separate contracts are considered a single performance obligation.
At times, the terms (such as the scope, pricing or both) of a contract are modified. If a contract is modified, an assessment should be performed to determine whether the modified contract should be accounted for as a new contract, an amendment to the existing contract or a combination. Please note certain industries may have different names for a contract modification, for example: a change order, amendment or a variation.
The contract modification is accounted for as a separate contract if both of the following conditions apply:
- The scope increases because of additional promised goods or services that are distinct to the contract.
- The price of the contract increased by an amount of consideration that reflects the standalone selling price of additional promised goods or services.
If the contract modification is not accounted for as a separate contract, at the date of the contract modification, the entity should account for the promised goods or services in one of the following ways:
- The contract modification would be considered a new contract and the existing contract would be terminated, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. Based on the remaining performance obligations the amount of consideration should be determined based on the consideration reported in the modified contract.
- The contract modification would be considered to be a part of the existing contract if the remaining goods and services are not distinct. The effect of the transaction price would be reported as an adjustment as of the date of the contract modification.
- If the remaining goods and services are a combination of items a and b, the entity should account for the modification in a manner that is consistent with items a and b.
The standard provides a practical expedient that is not required but can be chosen to combine contracts and account for them as a portfolio of contracts. In order to use the practical expedient the contracts must have similar characteristics and the results of applying the guidance are materially the same as the results of applying the guidance individually.
Step 2. Identify the Separate Performance Obligations in the Contract
Once a contract has been identified the contract must now be assessed to identify whether there is one or more performance obligations. A performance obligation is defined as a promise in a contract to transfer a distinct good, service, a bundle of goods or services or a series of distinct goods or services.
Each distinct group of goods or services should be accounted for as a separate performance obligation. If the good or service is determined not to be distinct, it should be combined with other goods or services identified as distinct in the contract.
Distinct Goods or Services
A good or service is considered to be distinct if both of the following criteria are met:
- Capable of being distinct - The customer is able to benefit from the item either alone or together with other resources readily available.
- Distinct within the context of the contract – The promise to transfer the goods or services is separately identifiable from other promises in the contract.
Series of Distinct Goods or Services
The revenue recognition standard defines a series of distinct goods or services as a pattern of transfer of goods and services to the customer. In order to be reported as a series of distinct goods or services both of the following criteria must be met:
- Control of each good or service is provided to the customer over time.
- The same method would be used to measure progress in providing each good or service to the customer.
Examples of a series of distinct goods or services include; a contract to deliver electricity or copier maintenance services.
Promises in Contracts with Customers
A contract will usually state the goods or services an entity promises to transfer to a customer. However, a contract may also include implied promises. Implied promised goods or services should be assessed to determine if they should be reported as a separate performance obligation. If promised goods or services are immaterial to the contract then they do not need to be assessed as a separate performance obligation. In addition, the performance of administrative tasks to set up a contract are not considered to be a performance obligation.
Examples of promised goods include:
- Sale of goods produced or purchased by an entity.
- Performing a contractually agreed upon task.
- Granting rights to goods or services to be provided in the future.
- Granting licenses.
- Constructing, manufacturing, or developing an asset on behalf of a customer.
Shipping and Handling Costs
An accounting policy election is available for shipping and handling activities. If the shipping and handling activities are performed after a customer obtains control of the goods, then the entity may elect to report that as an activity to fulfill the promise to transfer the goods. The activity would then not be evaluated to determine if it is a promised service to the customer. If the accounting policy is elected then it should be applied consistently to similar types of transactions and should be disclosed in the financial statements.
If shipping and handling activities are performed before a customer obtains control of the goods then it is not considered a performance obligation. Rather, shipping and handling is an activity to fulfill the entity’s promise to transfer the goods.
It is important to begin evaluating how the revenue recognition standard will affect your entity. For information about how this new standard will affect your entity, contact a member of your Sisterson engagement team.