The Five Steps of Revenue Recognition
This week, we take a look at the basic five steps of the new revenue recognition rules from the Financial Accounting Standards Board. The new standards affect all companies using International Financial Reporting Standards — public companies have to implement new standards in annual reporting periods beginning after December 15, 2017, while nonpublic entities have until after December 15, 2018.
If you’ve been keeping up with our weekly updates, you may already be familiar with these steps, but if you’ve missed a post, click here.
1. Identify Contracts
The revenue recognition standards apply to all contracts except for leases, insurance contracts and financial instruments. Contracts must identify all parties (usually your company and your client), the rights of each party and the payment terms.
You may combine multiple contracts for the same client as long as one of the following criteria is met:
- The contract was negotiated as a package deal
- The elements in the contract are interdependent on each other
- The goods or services included in the contract represent a single performance obligation
2. Identify Performance Obligations
The first two steps of the revenue recognition standards both fall under the umbrella of identification, and in particular, step two stipulates that every contract identify performance obligations.
A performance obligation is a promise to transfer a good or service. In other words, it’s a description of what clients can expect to receive. Performance obligations can be explicitly spelled out in the contract, or they can be implied based on your usual business practices or other written documents regarding your practices and policies.
3. Determine Transaction Price
With many contracts, this step is as simple as noting the price of the good or service. However, not all prices are static. In many cases, you may need to deal with variable pricing due to bonuses, rebates, discounts, contingency payments or other elements that may change throughout the course of the contract.
In these cases, the new revenue recognition standards dictate that you may estimate the price based on probability, or you may just choose the single most likely price. The latter is best suited to contracts with just a few amounts to consider, while the former is more effective for contracts with multiple elements or large numbers of similar contracts.
4. Allocate Transaction Prices
In addition to determining an overall price for the contract, you must break down the price and allocate the funds based on each performance objective in the contract. When allocating transaction prices, you can use the standalone price of each performance objective, but when that’s not possible, there are alternatives for estimating prices.
If the total price is less than the combined total of each item in the contract, that means you have applied a discount. In most cases, you need to allocate the discount evenly over all the items in the contract, but in key situations, you can opt to only apply the discount to select items.
5. Recognize Revenue
Finally, step five of the new rules explains when to identify revenue. Under the new standards, you should recognize the revenue on the books when the customer receives the goods or service. This happens when the asset has been physically transferred to the client and the client has assumed the risks and rewards of ownership. With service-oriented contracts, revenue recognition can happen when service is rendered or when you have the right to demand payment.
Although the new standards don’t start for a while, many companies are electing to start now, and some companies are even required to apply the new standards to old contracts retroactively. As a result, now is the time to begin the process of implementing the new standards.
Are you ready? Do you have a transition plan and a timetable?
Is your management team poised to handle the conversion, and do they have access to adequate resources?
For help through the changes, contact us directly.
This page from the FASB explains why new revenue recognition standards are a priority, and it contains answers to commonly asked questions such as who will be affected and how the new revenue standards affect generally accepted accounting principles (GAAP).
Written by a CPA, this link takes another look at the new revenue standards, and it breaks each step down into simple terms.