Understanding the Revised Accounting Model for Revenue Recognitionby
Revenue is a critical financial measure for businesses and their stakeholders. Company management, shareholders, lenders, analysts, investors, and regulators use revenue to monitor a company’s financial performance and general financial health. Revenue may also affect, among other things, an entity’s ability to attract investors and borrow money, and is also often used as a basis for determining certain employee compensation and benefits, like commissions, bonuses, and stock-based compensation. Anticipated revenue may also influence an entity’s tax-planning strategies.
With revenue touching so many aspects of a company’s well-being, it goes without saying that revenue recognition receives considerable attention in a company’s financial statements.
In recent years, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have identified areas for improvement in the accounting for revenue under both US GAAP and International Financial Reporting Standards (IFRS). Together, these boards have sought to unite the accounting for revenue in the United States and around the globe.
After years of deliberations on the appropriate accounting treatment for revenue, the FASB issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), on May 28, 2014, which introduces a new model to recognize revenue. At its core, the guidance provided states that an entity should recognize revenue to show the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
This ASU is still being clarified in a number of areas as implementation issues arise. New ASUs and proposed ASUs have been issued by the FASB to clarify a number of areas of the new guidance. While the amendments do not alter the core standard, companies must develop an in-depth understanding of the overall model and keep current with the recent updates that seek to clarify the narrow aspects of Topic 606.
ASU No. 2016-12
ASU No. 2016-12 addresses matters raised by the FASB-IASB Joint Transition Resource Group for Revenue Recognition regarding an entity’s implementation of and transition to Topic 606. The amendments do not change the core principles of Topic 606. Instead, the FASB provides clarification regarding specific issues, as follows:
Issue 1: Satisfying the collectibility and other criteria for identifying a contract. ASU No. 2016-12 adds guidance to clarify the purpose of the collectibility criterion for Step 1, Identifying a Contract, in the new revenue recognition model. In order to recognize revenue from a contract with a customer, a seller must determine whether a contract is valid and represents a substantive contract based on whether the customer has the ability and intent to pay. In addition, the amended guidance clarifies how a seller accounts for a contract that fails to satisfy the collectibility criterion.
Issue 2: Presentation of sales taxes. The amendments allow an entity to make an accounting policy election to exclude amounts collected for sales taxes and similar items from the transaction price.
Issue 3: Noncash consideration. ASU No. 2016-12 clarifies that an entity must use the contract inception date as the measurement date for the fair value of noncash consideration. Further, the amendments clarify that an entity can only apply the variable consideration guidance to variability that does not occur based on the form of consideration (that is, variability that is based upon other reasons).
Issue 4: Transitional guidance regarding modified contracts, completed contracts, and accounting change disclosures. ASU No. 2016-12 simplifies an entity’s transition to the revenue guidance in Topic 606 as follows:
Contract modifications: Topic 606 requires an entity to evaluate contract modifications that occurred before its adoption of the new revenue recognition guidance. ASU No. 2016-12 provides a practical expedient that permits an entity to reflect all modifications that occurred before the earliest period presented in the financial statements on an aggregate basis when identifying satisfied and unsatisfied performance obligations. This practical expedient eliminates the task of determining the separate effects of each contract modification.
Completed contracts: ASU No. 2016-12 clarifies the definition of a completed contract as one for which the entity has recognized all (or substantially all) of the revenue under the prior revenue recognition guidance. As a result, contract provisions that do not affect the amount of revenue recognized prior to implementing Topic 606 do not affect the determination of whether a contract is a completed contract. In addition, the amended guidance permits an entity to apply the modified retrospective approach either to all contracts or to completed contracts only.
Accounting changes: An entity that applies the retrospective approach is not required to disclose the effect of the accounting change for the period in which it adopts the new revenue recognition guidance. The entity must disclose, however, the effects of the new revenue recognition guidance on any prior periods that it adjusts retrospectively.
ASU No. 2016-11
During its March 3, 2016, meeting, the US Securities and Exchange Commission (SEC) announced that it is rescinding certain SEC staff observer comments as a result of the issuance of ASU No. 2014-09. ASU No. 2016-11 formally supersedes the related SEC paragraphs in the Codification.
ASU No. 2016-10
Because particular contract features are more prevalent in some industries than in others, it may be more difficult for companies in these industries to determine when control of a good or service has passed to the customer. For example, licenses are prominent in the software, pharmaceuticals, and media and entertainment industries. If a contract contains a license, an entity must evaluate whether control passes (and, therefore, revenue is recognized) at a point in time or over time.
Given this challenge, ASU No. 2016-10 introduces a distinction between functional intellectual property and symbolic intellectual property. In the case of functional intellectual property, the entity is not required to provide maintenance or support for the customer to use a license as is. The entity can recognize revenue at a point in time. Symbolic intellectual property, on the other hand, requires support or maintenance from the entity in order to maintain its value. As a result, the entity can only recognize revenue over time (as it also recognizes the ongoing maintenance costs).
ASU No. 2016-10 also discusses what constitutes a distinct performance obligation and whether shipping and handling is a separate performance obligation from the good or part of the same performance obligation when the entity sells a good to a customer and also ships it to the customer.
In short, if the shipping happens before control of the goods transfers to a customer, it is not a separate performance obligation. On the contrary, if it happens after the transfer of control, then it is a separate performance obligation. This is, for instance, the case in most contracts that require a good to be heavily customized for a customer because the transfer of control takes place as soon as the customization has occurred.
A seller may make an accounting policy election to characterize shipping and handling that occur after the customer obtains control as a cost of fulfilling the contract rather than as a separate performance obligation.
ASU No. 2016-08
ASU No. 2016-08 clarifies the factors to determine if an entity is a principal or an agent. The ASU rewrote the indicators from the perspective of the principal to tie them into the concept of control.
This update also seeks to clarify how the concept of control applies to service arrangements. Constituents wondered if it ever was possible to control a service until the service is performed. Entities sometimes use third parties to provide a service to a customer. These entities would never have concluded that they could be principals in a transaction if they were unable to control the service before it is provided. The FASB clarified that entities can control the right to a service.
Ultimately, the determination of the role of an entity in a transaction still requires a lot of judgment.
Proposed ASU No. 2016-250
The FASB issued this proposed ASU to respond to requests for clarification regarding the scope of Subtopic 610-20, which ASU No. 2014-09 introduced to the Codification. Proposed ASU No. 2016-250, if adopted, would amend the current guidance in Subtopic 610-20, particularly Section 610-20-15, Other Income—Gains and Losses from the Derecognition of Nonfinancial Assets—Scope and Scope Exceptions, and related provisions regarding the following:
1. Interaction with other asset derecognition guidance. Under the clarified guidance, an entity would apply the derecognition guidance in Subtopic 610-20 to all nonfinancial assets and in substance nonfinancial assets unless other guidance specifically applies to the transaction. The term “in substance nonfinancial assets” would include assets:
- Promised to a counterparty in a contract for which substantially all of the fair value is in nonfinancial assets; or
- Owned by a consolidated subsidiary whose assets’ fair value is concentrated in nonfinancial assets.
These amendments would also clarify that in substance financial assets exclude any group of assets or subsidiary that is a business or nonprofit entity. It would also exclude an investment (such as an equity method investment) regardless of the nature of the underlying assets.
As a result, under the amended guidelines, an entity would account for the derecognition and deconsolidation of all businesses and nonprofit activities under Subtopic 810-10, Consolidation—Overall. As a consequence of the proposed ASU, the transfer of investments in real estate entities would fall within the scope of the financial asset guidance because the exception to the scope of this guidance related to these types of transactions would be removed.
2. Unit of account. Under the amendments in Proposed ASU No. 2016-250, distinct nonfinancial assets would be the unit of account in applying the nonfinancial asset derecognition guidance in Subtopic 610-20, and entities would generally follow the model in Topic 606 to identify performance obligations and allocate the transaction price to performance obligations.
3. Partial sales. The proposed guidance would address the accounting for partial sales of nonfinancial assets. ASU No. 2014-09 replaced the previous guidance in Subtopic 360-20, Property, Plant, and Equipment—Real Estate Sales, with Topic 606 and Subtopic 610-20, but it did not address partial sales, which are common in the real estate industry.
The proposed amendments would establish how a reporting entity would account for a decrease in ownership of a subsidiary and the related derecognition of nonfinancial assets based on whether it has retained or transferred a controlling financial interest. These amendments would also eliminate Section 845-10-30, Nonmonetary Transactions—Overall—Initial Measurement. Instead, an entity would apply the model in Subtopic 610-20. Moreover, an entity would apply the amended guidance on partial sales to contributions of a nonfinancial asset to a joint venture or similar investees.
Proposed ASU No. 2016-240
Proposed ASU No. 2016-240 introduces the following changes, which are not intended to have a significant effect on an entity’s application of ASU No. 2014-09:
1. Preproduction costs under long-term supply arrangements. ASU No. 2014-09 establishes the cost guidance for long-term supply arrangements in Subtopic 340-40, Other Assets and Deferred Costs—Contracts with Customers. Stakeholders have expressed concerns that it is unclear which contracts are within the scope of this new guidance as opposed to the existing guidance in Subtopic 340-10, Other Assets and Deferred Costs—Overall.
The proposed amendments would supersede the cost guidance for long-term supply arrangements in Subtopic 340-10. As a result, after the adoption of ASU No. 2014-09, entities would apply the guidance in Subtopic 340-40.
2. Considerations on the impairment of contract costs. An entity may capitalize certain contract costs under Subtopic 340-40. These costs must be assessed for impairment. The proposed amendments would clarify that an entity must include the following considerations when assessing capitalized costs for impairment:
- Expected contract renewals and extensions.
- The amount of consideration received but not recognized as revenue.
- The amount of consideration expected in the future.
3. Interaction of the impairment guidance for contract costs with other guidance. Subtopic 340-40 establishes impairment guidelines for capitalized contract costs. Questions have been raised regarding how this guidance interacts with the impairment provisions in other Topics. The proposed amendments would provide a hierarchy for performing impairment testing, as follows:
- First, an entity must assess assets outside of the scope of Topic 340, Other Assets and Deferred Costs, for impairment.
- Second, an entity must assess assets within the scope of Topic 340 for impairment.
- Last, an entity must assess asset groups and reporting units within the scope of Topic 360 and Topic 350.
4. Provisions for losses on construction-type and production-type contracts. The guidance in Topic 606, Revenue from Contracts with Customers, as established by ASU No. 2014-09, changes the level at which an entity must assess provisions for losses from the segment level to the performance obligation level. For construction-type and production-type contracts, however, an entity must continue to apply the guidance in Subtopic 605-35, Revenue Recognition—Construction-Type and Production-Type Contracts.
Stakeholders have expressed concerns regarding the requirement to perform the loss assessment at the lower level despite the fact that the FASB retained the guidance in Subtopic 605-35. The proposed amendments would require an entity to perform the loss assessment at the contract level at a minimum. Proposed ASU No. 2016-240 would also permit an entity to make an accounting policy election to perform the loss assessment at the performance obligation level.
5. Scope of Topic 606. Topic 606 includes a scope exception for insurance contracts within the scope of Topic 944, Financial Services—Insurance. The proposed amendments would clarify that this scope exception applies to all contracts under Topic 944, including investment contracts that do not subject an entity to insurance risk, by removing the word “insurance” from the exception.
6. Remaining performance obligation disclosures. An entity is required to disclose information regarding its remaining performance obligations. This requirement includes disclosure of the aggregate amount of the transaction price that the entity allocated to unsatisfied performance obligations at the end of the reporting period.
Topic 606 has certain practical expedients for this disclosure requirement. Stakeholders have asked the FASB to consider adding additional practical expedients for contracts in which an entity is not required to estimate variable consideration for revenue recognition. Accordingly, the proposed amendments add practical expedients for specific situations on performance obligations in which revenue recognition is not dependent upon variable consideration. Proposed ASU No. 2016-240 would additionally require an entity to disclose further information when electing one of these practical expedients.
7. Example of a contract modification. The implementation guidance and illustrations in Topic 606 includes Example 7 to illustrate the contract modification guidance. The proposed amendments would change this example to better align it with the contract modification guidance.
8. Fixed-odds wagering contracts in the casino industry. ASU No. 2014-09 supersedes the guidance in Subtopic 924-605, Entertainment—Casinos—Revenue Recognition, that identifies fixed-odds wagering contracts as gaming revenue. As a result, questions have been raised regarding whether fixed-odds wagering contracts fall within the scope of Topic 606 or Topic 815, Derivatives and Hedging.
The proposed amendments would provide additional guidance on these contracts by:
- Creating a new Subtopic 924-815, Entertainment—Casinos—Derivatives and Hedging, that would provide a scope exception for fixed-odds wagering contracts from the derivative guidance.
- Providing a scope exception in Topic 815 for fixed-odds wagering contracts from a casino entity.
9. Cost capitalization for advisors to private and public funds. ASU No. 2014-09 moves the cost guidance in Subtopic 946-605, Financial Services—Investment Companies—Revenue Recognition, to Subtopic 946-720, Financial Services—Investment Companies—Other Expenses. By moving this guidance, inconsistencies may result in the accounting for offering costs from advisors to public and private funds.
The FASB did not intend to change practice in making this move, so the proposed amendments would align the cost capitalization guidance for advisors to both types of funds under Topic 946, Financial Services—Investment Companies.
Effective Dates and Transition Methods
The effective date of the revenue recognition standard was delayed by a year by ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. Prior to this ASU, the new revenue recognition guidance would have become effective for annual periods beginning after Dec. 15, 2016, for public companies and a year later for private companies.
The FASB and the IASB reconsidered the effective date in light of the many comments that stressed the amount of work required for the implementation of the standard and the questions the FASB and the IASB were still debating.
In the 2011 exposure draft for revenue recognition, the FASB proposed that all public entities would be required to apply the revenue guidance on a full retrospective basis. Many users of financial statements (such as investors and analysts) supported a retrospective application because it would provide comparable current- and prior-year financial information.
Many preparers of financial statements, however, submitted comment letters to the FASB expressing their concerns about a retrospective application. Among other concerns, entities with long-term contracts pointed out that they might not have sufficient data to account for past contracts or outstanding contracts that have been in existence for many years. These entities further stated that, in the event that sufficient data is available, the data may not be reliable if it has been housed on nonledger systems that are not subject to the company’s ongoing internal controls.
The FASB considered the feedback received in developing the two transition methods provided in the final standard. These transition methods provide certain relief to preparers (such as optional practical expedients) as compared to a traditional retrospective approach.
In determining which transition method to elect, an entity is urged to consider not only which method is easier to apply but also what the expectations are of the investor community. For example, if a large number of entities (or the key players) in a particular industry indicate that they plan to apply a specific approach, investors may expect for other entities in the industry to follow suit. Therefore, in addition to considering which transition method is most practical to apply, an entity is encouraged to be mindful of the transition methods being chosen by its industry peers.
It’s Never Too Early to Prepare
Although the effective date of the standard is not until the end of 2017, many preparers of financial statements have indicated that it will take a substantial amount of time for them to implement the new rules. Therefore, no date is too early for a preparer to begin to develop its action plan for how it will tackle and apply the new standard.
Anne-Lise Vivier, CPA, is the managing editor of GAAP Reporter, our GAAP Critical Issues Series, and a number of other accounting publications with Thomson Reuters Checkpoint within the Tax & Accounting business of Thomson Reuters. She is...