Heads Up — Boards Issue Guidance on Revenue From Contracts With Customers
Volume 21, Issue 14
On May 28, 2014, the FASB and IASB issued their final standard on revenue from contracts with customers. The standard, issued as ASU 2014-09 1 by the FASB and as IFRS 15 2 by the IASB, outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance.
Editor’s Note: The SEC has indicated that it plans to review and update the revenue recognition guidance in SAB Topic 13 3 when the ASU is issued. The extent to which the ASU’s guidance will affect a public entity will depend on whether the SEC removes or amends the guidance in SAB Topic 13 to be consistent with the new revenue standard.
In addition to discussing certain differences between the ASU and current U.S. GAAP, this Heads Up summarizes the final standard’s (1) key provisions, including the specific steps for recognizing revenue; (2) other provisions and impacts, including tax implications; (3) disclosure requirements; and (4) effective date and transition.
Editor’s Note: Because the ASU supersedes most industry-specific revenue recognition guidance, entities in certain industries may face significant accounting and operational challenges when applying the ASU, potentially resulting in changes in the amount of revenue they recognize and the timing of revenue recognition. For insight into how the new standard will affect specific industries, look for future publications in Deloitte’s Industry Spotlight series.
The goals of the revenue recognition project are to clarify and converge the revenue recognition principles under U.S. GAAP and IFRSs and to develop guidance that would streamline and enhance revenue recognition requirements while also providing “a more robust framework for addressing revenue issues.” The boards believe that the standard will improve the consistency of requirements, comparability of revenue recognition practices, and usefulness of disclosures.
Editor’s Note: Five FASB board members voted affirmatively to issue the ASU, one dissented, and one abstained. The dissenting member opposed the issuance of the ASU on the basis that certain of its key requirements, specifically the collectibility threshold and the constraint on variable consideration, are not consistent with the core principle of the project. The IASB unanimously voted in favor of issuing IFRS 15.
The boards’ 2008 discussion paper4 on revenue recognition represented a significant milestone in the project. The project picked up momentum with the issuance of the June 2010 exposure draft (ED), for which the boards received nearly 1,000 comment letters. Then, in November 2011, the boards issued their revised ED after conducting extensive outreach and redeliberating almost every aspect of the original proposal. Since then, the revenue project has been one of the boards’ top priorities. After further outreach and deliberations, the boards modified the proposal and issued the final standard. In addition, the boards announced plans to create a “joint transition resource group” to research standard-related implementation issues. The resource group’s input is intended to help the boards resolve any diversity in practice. Therefore, the boards may issue additional revenue guidance or interpretations before the ASU’s effective date in 2017.
Key Provisions of the ASU
The core principle of the revenue model is that “an entity recognizes revenue to depict 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.” In applying the revenue model to contracts within its scope, an entity will:
- Identify the contract(s) with a customer (step 1).
- Identify the performance obligations in the contract (step 2).
- Determine the transaction price (step 3).
- Allocate the transaction price to the performance obligations in the contract (step 4).
- Recognize revenue when (or as) the entity satisfies a performance obligation (step 5).
The ASU applies to all contracts with customers 5 except those that are within the scope of other topics in the FASB Accounting Standards Codification. 6 Certain of the ASU’s provisions also apply to transfers of nonfinancial assets, including in-substance nonfinancial assets that are not an output of an entity’s ordinary activities (e.g., sales of (1) property, plant, and equipment; (2) real estate; or (3) intangible assets). Such provisions include guidance on recognition (including determining the existence of a contract and control principles) and measurement (existing accounting guidance applicable to these transfers (e.g., ASC 360-20) has been amended or superseded).
Editor’s Note: An entity would continue to apply the derecognition guidance in ASC 810-10-40 when transfers or sales are not “in-substance nonfinancial assets” and the nonfinancial assets are held within a subsidiary that meets the definition of a business. The scope of ASC 360-20 (formerly FASB Statement 66 7) has been limited to accounting for a “real estate sale-leaseback transaction.” The ASU does not specifically address partial sales of nonfinancial assets or define the term “in-substance asset.”
When a contract includes multiple performance obligations (deliverables), some of which are within the scope of other standards, any separation and initial measurement requirements of the other standards are applied first and the deliverables within the scope of the revenue model are ascribed any residual amount. If there are no separation or initial measurement requirements in those other standards, the requirements in ASC 606 are applied.
The ASU should be applied on an individual contract basis. However, a “portfolio approach” is permitted provided that it is reasonably expected that the impact on the financial statements will not be materially different from the impact when the standard is applied on an individual contract basis.
Compared with current U.S. GAAP, the ASU would also require significantly expanded disclosures about revenue recognition (see Required Disclosures section below).
Steps for Recognizing Revenue
Identifying the Contract With the Customer (Step 1)
A contract can be written, verbal, or implied; however, the ASU applies to a contract only if all of the following criteria are met:
- “The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations.”
- “The entity can identify each party’s rights regarding the goods or services to be transferred.”
- “The entity can identify the payment terms for the goods or services to be transferred.”
- “The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract).”
- “It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.” 8
Editor’s Note: Entities should be aware that the “probable” threshold for collectibility, as used in the criterion above for identifying the contract with the customer, is defined differently under U.S. GAAP than it is under IFRSs. In U.S. GAAP, ASC 450-20 (formerly FASB Statement 5 9) states that the term “probable” refers to a “future event or events [that] are likely to occur.” In IFRSs, “probable” means “more likely than not.” Because “more likely than not” under U.S. GAAP is a lower threshold than “probable,” an entity may encounter differences between U.S. GAAP and IFRSs in determining whether a contract exists.
If a contract does not meet these criteria at contract inception, an entity must continue to reassess the criteria to determine whether they are subsequently met. If the above criteria are not met in a contract with a customer, the entity is precluded from recognizing revenue under the contract until the consideration received is nonrefundable and either (1) all performance obligations in the contract have been satisfied and substantially all the promised consideration has been received or (2) the contract has been terminated or canceled. If those conditions are not met, any consideration received would be recognized as a liability.
Identifying the Performance Obligations (Step 2)
The ASU provides guidance on evaluating the promised “goods or services” 10 in a contract to determine each performance obligation (i.e., the unit of account). A performance obligation is each promise to transfer either of the following to a customer:
- “A good or service (or a bundle of goods or services) that is distinct.”
- “A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.” 11
A promised good or service is distinct (and therefore a performance obligation) if both of the following criteria are met:
- Capable of being distinct — “The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.”
- Distinct within the context of the contract — “The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract” (the ASU provides specific indicators of this criterion — see Editor’s Note below).
The ASU defines a readily available resource as “a good or service that is sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity.” If an entity regularly sells a good or service on a stand-alone basis, the customer can benefit from that good or service on its own and the criterion in the first bullet would be met.
The following diagram illustrates the ASU’s process for identifying performance obligations in a contract:
Editor’s Note: The ASU’s guidance on determining whether a customer can benefit from a good or service on its own, or with other readily available resources, is generally consistent with the current guidance in ASC 605-25 on determining whether a good or service has “stand-alone value.” However, the ASU also contains a new requirement under which entities must evaluate a good or service to determine whether it is “separately identifiable from other promises in the contract.” The ASU provides the following indicators for evaluating whether a promised good or service is separable from other promises in a contract:
Entities may need to use significant judgment when determining whether the goods or services in a contract are “highly dependent on, or highly interrelated with” or whether they “significantly modify or customize” each other. This new concept may require entities to account for a bundle of goods or services, which may qualify for separate accounting under current U.S. GAAP, as a single performance obligation (unit of account).
Determining the Transaction Price (Step 3)
The ASU requires an entity to determine the transaction price, which is the amount of consideration to which it expects to be entitled in exchange for the promised goods or services in the contract. The transaction price can be a fixed amount or can vary because of “discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items.” An entity must consider the following when determining the transaction price under the ASU:
- Variable consideration — When the transaction price includes a variable amount, an entity is required to estimate the variable consideration by using either an “expected value” (probability-weighted) approach or a “most likely amount” approach, whichever is more predictive of the amount to which the entity will be entitled (subject to the “constraint” discussed below).
- Significant financing components — Adjustments for the time value of money are required if the contract includes a “significant financing component” (as defined by the ASU).
- Noncash consideration — To the extent that a contract includes noncash consideration, an entity is required to measure that consideration at fair value.
- Consideration payable to the customer — Like current U.S. GAAP, the ASU requires that consideration payable to the customer be reflected as an adjustment to the transaction price unless the consideration is payment for a distinct good or service (as defined by the ASU).
Constraining Estimates of Variable Consideration
Some or all of an estimate of variable consideration is only included in the transaction price to the extent that it is probable 12 that subsequent changes in the estimate would not result in a “significant reversal” of revenue (this concept is commonly referred to as the “constraint”). The ASU requires entities to perform a qualitative assessment that takes into account both the likelihood and the magnitude of a potential revenue reversal and provides factors that could indicate that an estimate of variable consideration is subject to significant reversal (e.g., susceptibility to factors outside the entity’s influence, long period before uncertainty is resolved, limited experience with similar types of contracts, practices of providing concessions, or a broad range of possible consideration amounts). This estimate would be updated in each reporting period to reflect changes in facts and circumstances. In addition, the constraint does not apply to sales- or usage-based royalties derived from the licensing of intellectual property; rather, consideration from such royalties is only recognized as revenue at the later of when the performance obligation is satisfied or when the uncertainty is resolved (e.g., when subsequent sales or usage occurs).
Editor’s Note: Under current U.S. GAAP, the amount of revenue recognized is generally limited to the amount that is not contingent on a future event (i.e., the price is no longer variable). Under the ASU, an entity must include some or all of an estimate of variable (or contingent) consideration in the transaction price (which is the amount to be allocated to each unit of account and recognized as revenue) when the entity concludes that it is probable that changes in its estimate of such consideration will not result in significant reversals of revenue in subsequent periods. This less restrictive guidance will most likely result in earlier recognition of revenue under the ASU than under current U.S. GAAP. Further, entities will need to exercise significant judgment when performing this assessment and could therefore find it challenging to consistently apply the ASU’s requirements throughout their organization.
Allocating the Transaction Price (Step 4)
Under the ASU, when a contract contains more than one performance obligation, an entity would generally allocate the transaction price to each performance obligation on a relative stand-alone selling price basis. The ASU states that “[t]he best evidence of a standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers.” If the good or service is not sold separately, an entity must estimate it by using an approach that maximizes the use of observable inputs. Acceptable estimation methods include, but are not limited to, adjusted market assessment, expected cost plus a margin, and a residual approach (when it is not directly observable and either highly variable or uncertain). The ASU indicates that if certain conditions are met, there are limited exceptions to this general allocation requirement. When those conditions are met, a discount or variable consideration must be allocated to one or more, but not all, distinct goods or services or performance obligations in a contract.
Changes in the transaction price (e.g., changes in an estimate of variable consideration) after contract inception would be allocated to all performance obligations in the contract on the same basis (unless the terms of the contract meet certain criteria that allow for allocation of a discount or variable consideration to one or more, but not all, performance obligations).
Editor’s Note: The ASU allows entities to use a residual approach in allocating contract consideration but only when the stand-alone selling price of a good or service is not directly observable and either “highly variable or uncertain.” An entity will need to use judgment in determining whether these criteria are met. Because the ASU’s allocation guidance is similar to the guidance in ASC 605-25, entities that have historically applied ASC 605-25 and have established stand-alone selling prices for goods or services (through either separate sales or estimations) may not meet the ASU’s criteria for using a residual approach.
Recognizing Revenue When (or as) Performance Obligations Are Satisfied (Step 5)
Under the ASU, a performance obligation is satisfied (and the related revenue recognized) when “control” of the underlying goods or services (the “assets”) related to the performance obligation is transferred to the customer. The ASU defines “control” as “the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.” An entity must first determine whether control of a good or service is transferred over time. If so, the related revenue is recognized over time as the good or service is transferred to the customer. If not, control of the good or service is transferred at a point in time.
Control of a good or service (and therefore satisfaction of the related performance obligation) is transferred over time when at least one of the following criteria is met:
- “The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.”
- “The entity’s performance creates or enhances an asset . . . that the customer controls as the asset is created or enhanced.”
- “The entity’s performance does not create an asset with an alternative use to the entity . . .
and the entity has an enforceable right to payment for performance completed to date.”
If a performance obligation is satisfied over time, an entity recognizes revenue by measuring progress toward satisfying the performance obligation in a manner that best depicts the transfer of goods or services to the customer. The ASU provides specific guidance on measuring progress toward completion, including the use and application of output and input methods.
Editor’s Note: The ASU notes that, in certain circumstances, an entity may not be able to reasonably measure progress toward complete satisfaction of a performance obligation. In such circumstances, the entity would be required to recognize revenue to the extent of costs incurred (i.e., at a zero profit margin) if the entity expects to recover such costs. The ASU does not permit entities to use a completed-contract method (such as that described in ASC 605-35 (formerly SOP 81-1 13)).
If a performance obligation is not satisfied over time, it is deemed satisfied at a point in time. Under the ASU, entities would consider the following indicators in evaluating the point at which control of an asset has been transferred to a customer:
- “The entity has a present right to payment for the asset.”
- “The customer has legal title to the asset.”
- “The entity has transferred physical possession of the asset.”
- “The customer has the significant risks and rewards of ownership of the asset.”
- “The customer has accepted the asset.”
Editor’s Note: Under the ASU, entities recognize revenue by using a control-based model rather than the risks-and-rewards model of current U.S. GAAP. However, the boards decided to include “significant risks and rewards” as a factor for entities to consider in evaluating the point in time at which control of a good or service is transferred to a customer. The boards believe that the ASU’s model will result in (1) a more consistent determination of when goods or services are transferred to a customer, (2) easier identification of performance obligations, and (3) similarities in the use of the term “control” in the existing definition of an asset.
For many entities, the ASU’s control-based model will not significantly affect how they recognize revenue for contracts with customers. However, the model may significantly affect certain entities that either were within the scope of ASC 605-35 (formerly SOP 81-1) or were specifically excluded from the scope of such guidance (including construction and production-type contracts, contract manufacturers, suppliers of customized products, and other similar manufacturers). Specifically, entities cannot presume that arrangements currently within the scope of ASC 605-35 that are accounted for by using a percentage-of-completion method will meet the ASU’s requirements for recognition of revenue over time (i.e., revenue for certain arrangements may need to be recognized at a point in time).
Conversely, entities with arrangements to manufacture goods that are currently excluded from the scope of ASC 605-35 and for which revenue is recognized at a point in time may meet the ASU’s requirements for revenue recognition over time. For example, if an entity’s obligation to produce a customized product meets the criteria for revenue recognition over time (the entity’s performance does not create an asset with an alternative use and the entity has a right to payment for performance completed to date if the customer terminates the contract), revenue related to that product would be recognized over the period in which the product is produced, not when the product is delivered to the customer (as is generally the case under current U.S. GAAP).
Other Provisions and Impacts of the Revenue Model
In addition to the provisions discussed above, the standard provides implementation guidance on several other important topics, including the accounting for certain revenue-related costs. Appendix A in the attached PDF summarizes the ASU’s guidance on the following:
- Combination of contracts.
- Contract modifications.
- Contract costs.
- Rights of return.
- Principal-versus-agent considerations.
- Customer options for additional goods or services.
- Nonrefundable up-front fees.
- Customer’s unexercised rights.
- Repurchase agreements.
- Consignment arrangements.
- Bill-and-hold arrangements.
- Customer acceptance terms.
Further, although the ASU does not provide any specific income-tax-related guidance, because tax accounting methods are often in line with the financial reporting accounting (“book”) method for revenue recognition, any changes to the amount or timing of “book” revenue as a result of the ASU may also affect taxable income. Appendix B in the attached PDF summarizes the potential tax implications related to adoption of the ASU.
The ASU requires entities to disclose both quantitative and qualitative information that enables “users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.” The ASU’s disclosure requirements, which are significantly more comprehensive than those in existing revenue standards, include the following (there are certain exceptions for nonpublic entities; see Appendix C in the attached PDF for a summary of these exceptions):
- Presentation or disclosure of revenue and any impairment losses recognized separately from other sources of revenue or impairment losses from other contracts.
- A disaggregation of revenue to “depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors” (the ASU also provides implementation guidance).
- Information about (1) contract assets and liabilities (including changes in those balances), (2) the amount of revenue recognized in the current period that was previously recognized as a contract liability, and (3) the amount of revenue recognized in the current period that is related to performance obligations satisfied in prior periods.
- Information about performance obligations (e.g., types of goods or services, significant payment terms, typical timing of satisfying obligations, and other provisions).
- Information about an entity’s transaction price allocated to the remaining performance obligations, including (in certain circumstances) the “aggregate amount of the transaction price allocated to the performance obligations that are unsatisfied (or partially unsatisfied)” and when the entity expects to recognize that amount as revenue.
- A description of the significant judgments, and changes in those judgments, that affect the amount and timing of revenue recognition (including information about the timing of satisfaction of performance obligations, the determination of the transaction price, and the allocation of the transaction price to performance obligations).
- Information about an entity’s accounting for costs to obtain or fulfill a contract (including account balances and amortization methods).
- Information about policy decisions (i.e., whether the entity used the practical expedients for significant financing components and contract costs allowed by the ASU).
The ASU requires entities, on an interim basis, to disclose information required under ASC 270 as well as to provide the disclosures (described above) about (1) the disaggregation of revenue, (2) contract asset and liability balances and significant changes in those balances since the previous period-end, and (3) the transaction price allocated to the remaining performance obligations.
Editor’s Note: IFRS 15 only requires entities to disclose the disaggregation of revenue in addition to the information required under IAS 3414 for interim periods.
Effective Date and Transition
The ASU is effective for annual reporting periods (including interim reporting periods within those periods) beginning after December 15, 2016, for public entities. Early application is not permitted (however, early adoption is optional for entities reporting under IFRSs). In addition, the ASU provides relief for nonpublic entities by delaying the effective date; see Appendix C in the attached PDF for more information about the alternative effective dates for nonpublic entities.
Entities have the option of using either a full retrospective or a modified approach to adopt the guidance in the ASU:
- Full retrospective application — Retrospective application would take into account the requirements in ASC 250 (with certain practical expedients).
- Modified retrospective application — Under the modified approach, an entity recognizes “the cumulative effect of initially applying [the ASU] as an adjustment to the opening balance of retained earnings . . . of the annual reporting period that includes the date of initial application” (revenue in periods presented in the financial statements before that date is reported under guidance in effect before the change). Under the modified approach, the guidance in the ASU is only applied to existing contracts (those for which the entity has remaining performance obligations) as of, and new contracts after, the date of initial application. The ASU is not applied to contracts that were completed before the effective date (i.e., an entity has no remaining performance obligations to fulfill). Entities that elect the modified approach must disclose an explanation of the impact of adopting the ASU, including the financial statement line items and respective amounts directly affected by the standard’s application. The following chart illustrates the application of the ASU and legacy GAAP under the modified approach for a public entity with a calendar year-end:
Editor’s Note: The modified transition approach provides entities relief from having to restate and present comparable prior-year financial statement information; however, entities will still need to evaluate existing contracts as of the date of initial adoption under the ASU to determine whether a cumulative adjustment is necessary. Therefore, entities may want to begin considering the typical nature and duration of their contracts to understand the impact of applying the ASU and to determine the transition approach that is practical to apply and most beneficial to financial statement users.
Entities should also carefully evaluate the respective advantages and disadvantages of each of the transition methods before selecting their method of adopting the ASU. The transparent trend information provided under the full retrospective approach may be most effective for entities that expect to experience a significant change. Also, entities that have significant deferred revenue balances may prefer a full retrospective approach to ensure that such revenue is not “lost” from operations by its recognition as a cumulative-effect adjustment to retained earnings. However, the full retrospective approach will require a significant effort, since the adjustments to prior reported results will change not only the revenue recognized but also the other “direct effects of a change” as defined in ASC 250. Also, the full retrospective approach will require public entities to continue to evaluate how far back an entity must update its results (e.g., whether the five-year table required by Regulation S-K, Item 301, 15 needs to be restated). Management should begin this analysis, in consultation with key external stakeholders (such as investors and auditors), and be mindful of the required disclosures under SAB 74 16 and the SEC staff’s expectation that those disclosures increase in explanation and specificity as the transition date approaches.
1 FASB Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers.
2 IFRS 15, Revenue From Contracts With Customers.
3 SEC Staff Accounting Bulletin Topic 13, “Revenue Recognition.”
4 FASB and IASB Discussion Paper, Preliminary Views on Revenue Recognition in Contracts With Customers.
5 Contracts with counterparties that are collaborators or partners, rather than customers, do not represent contracts with customers and are outside the scope of the ASU.
6 The ASU does not apply to contracts within the scope of ASC 840 (leases) and ASC 944 (insurance); contractual rights or obligations within the scope of ASC 310, ASC 320, ASC 323, ASC 325, ASC 405, ASC 470, ASC 815, ASC 825, and ASC 860 (primarily various types of financial instruments); contracts within the scope of ASC 460 (guarantees other than product or service warranties); and nonmonetary exchanges whose purpose is to facilitate a sale to another party (ASC 845). (For titles of FASB Accounting Standards Codification references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”)
7 FASB Statement No. 66, Accounting for Sales of Real Estate.
8 In assessing whether it is probable that the entity will collect the consideration, an entity would consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration evaluated may be less than the price stated in the contract if the consideration is variable because the entity may offer price concessions (see step 3 on determining the transaction price).
9 FASB Statement No. 5, Accounting for Contingencies.
10 Although the ASU does not define goods or services, it includes several examples, such as goods produced (purchased) for sale (resale), granting a license, and performing contractually agreed-upon tasks.
11 A series of distinct goods or services has the same pattern of transfer if both of the following criteria are met: (1) each distinct good or service in the series would meet the criteria for recognition over time and (2) the same measure of progress would be used to depict performance in the contract. For example, each individual day of a weekly cleaning service could be a distinct performance obligation, but in this case the entire week (the series) should be considered a single performance obligation.
12 Like the term “probable” in step 1 regarding the collectibility threshold, “probable” in this context has the same meaning as in ASC 450-20: “the event or events are likely to occur.” In IFRS 15, the IASB uses the term “highly probable,” which has the same meaning as the FASB’s “probable.”
13 AICPA Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts.
14 IAS 34, Interim Financial Reporting.
15 SEC Regulation S-K, Item 301, “Selected Financial Data.”
16 SEC Staff Accounting Bulletin Topic 11.M, “Disclosure of the Impact That Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period” (SAB 74).