If you are in the accounting/finance world, you have likely heard something about changes coming to revenue recognition that will be applicable to private companies starting in 2019. As with every major shift in accounting rules, there is probably quite a bit of angst and uncertainty as to what impact this will have on your organization.
The standard introduces a five-step model to the process of evaluating contracts for their pattern of revenue recognition. They are as follows:
- Identify the contract with the customer
- Determine the performance obligations (goods or services to be provided) within the contract
- Determine the consideration to be received from the contract
- Allocate the consideration to the identified performance obligations
- Recognize revenue when or as the identified performance obligations are satisfied
While conceptually these steps may seem straightforward, there are numerous nuances imbedded within the five-step model. For this post, I will focus on the areas that will be most important to many private companies.
Identifying Performance Obligations
Identifying separate performance obligation is one the most critical elements of the new standard. This essentially determines the unit of account for revenue recognition.
The standard defines performance obligation as a promise to provide goods or services that is distinct, satisfied over time, or measured by the same method (ex. Weekly cleaning contract).
Assurance vs. Service Warranties
The new standard identifies two types of warranties:
- Assurance warranties –consists of assurances that the product will function as specified. As is current practice, at the time of the sale, an entity would estimate the costs to be incurred under the warranty and accrue for them with the corresponding debt recorded as an expense.
- Service warranties –provides the customer with an additional service and represents a separate performance obligation.
In general, a warranty is considered a service warranty if the customer can purchase the warranty separately. If so, this fact indicates that the warranty is a separate service and, as such, is a service warranty. There are detailed criteria in the standard regarding warranties, which companies may need to consider further.
In Step 3 (determining the consideration to be received under the contract), the topic of variable consideration is introduced.
Variable consideration can arise due to:
- Discounts, rebates, refunds, and credits
- Price concessions, incentives, and performance bonuses
- Consideration that is contingent on the occurrence or non-occurrence of a future event
Such amounts need to be evaluated, estimated, and calculated as part of Step 3. There is detailed guidance in the standard regarding when and how to measure such variable consideration.
Point in Time vs. Over Time Recognition
The standard defines two methods of recognizing revenue: point in time vs. over time. Point in time occurs when revenue is recognized entirely at one point when control of the goods or services is transferred to the customer. However, in certain circumstances, it is appropriate to recognize revenue over a period of time if any of the following criteria are met:
- The customer simultaneously receives and consumes the economic benefits provided by the vendor’s performance.
- The vendor creates or enhances an asset controlled by the customer.
- The vendor’s performance does not create an asset for which the vendor has an alternative use, and the vendor has an enforceable right to payment for performance completed to date.
There are several different methods to utilize in recognizing revenue over time. The most common of which is the percentage of completion approach.
Financial Statement Disclosures
The disclosures for private companies are less numerous than for public companies, but they are still quite extensive. Below are a few of the key disclosure requirements.
- Revenue recognized from contracts with customers (if other sources of revenue)
- Any credit losses recorded on any receivables or contract assets related to contracts with customers (separately from other credit losses, if applicable)
- Revenue disaggregated according to the timing of transfer of goods or services (point in time vs. over time)
- Qualitative information about how economic factors (type of customer, geographical location of customers, and type of contract) affect the nature, amount, timing and uncertainty of revenue and cash flows
- Information about its performance obligations in contracts with customers
- Significant judgments, and changes in judgments, made in applying the guidance of ASC 606 that significantly affect the determination of the amount and timing of revenue from contracts with customers
- Methods, inputs, and assumptions used to assess whether an estimate of variable consideration is constrained and the obligations for returns, refunds, and other similar obligations
These are just of few of the key items to be aware of with the new standard. However, there are many other significant elements of the rule for specific industries and revenue streams to consider. For assistance with applying these new standards to your closely held or family-owned business, please contact the firm.
By Ryan Livengood, CPA, CVA, Senior Manager