The Financial Accounting Standards Board (“FASB”) issued ASC 606, Revenues from Contracts with Customers, and ASC 340-40, Other Assets and Deferred Costs – Contracts with Customers, and the International Accounting Standards Boards (“IASB”) issued IFRS 15, Revenue from Contracts with Customers in May 2014. It generally converged both revenue standards eliminating most differences between U.S. GAAP and IFRS in accounting for revenue from contracts with customers. It took effect in 2018 for annual reporting periods beginning after December 15, 2017 for public entities and annual reporting periods beginning after December 15, 2018 for nonpublic entities, and addresses virtually all industries in U.S. GAAP, including those that previously followed industry-specific guidance such as the real estate, construction and software industries. For many entities, the timing, pattern of revenue recognition and capitalization of certain costs will change. In some areas, the changes will be very significant and will require careful planning.
The new standard also introduces significantly enhanced disclosure requirements. In practice, even if the timing and pattern of revenue recognition does not change, it is certain that new and modified processes will be needed in order to comply with the disclosure requirements.
The FASB’s joint project with the IASB to develop a new accounting standard for revenue recognition dates back over a decade. The U.S. and international standard setters had noted inconsistencies and weaknesses in each of their respective accounting standards. In IFRS, there was significant diversity in practice because existing standards contained limited guidance for a range of significant topics, such as accounting for contracts with multiple elements; Under U.S. GAAP, concepts for revenue recognition had been supplemented with a broad range of industry specific guidance, which had resulted in economically similar transactions being accounted for differently.
In addition, both the FASB and the IASB noted that existing disclosure requirements were inadequate. The previous requirements often resulted in insufficient information for users of financial statements to understand the sources of revenue, and the key judgments and estimates that had been made in its recognition. This often led to the information being disclosed as ‘boilerplate’ and uninformative.
The new revenue standards establish a single, comprehensive framework, which sets out how much revenue is to be recognized, and when. The core principle is that revenue is recognized as a result of an entity transferring promised goods or services to customers.
Subsequent to issuing new accounting standards for revenue recognition, the FASB and IASB (the “Boards”) formed the Joint Transition Resource Group for Revenue Recognition (“TRG”). The goals of the TRG are to inform the Boards about potential implementation issues and to assist stakeholders in understanding specific aspects of the new guidance. As a result of TRG deliberations, the FASB has made the following updates to ASC 606:
- ASU 2015-14, Deferral of the Effective Date
- ASU 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net)
- ASU 2016-10, Identifying Performance Obligations and Licensing
- ASU 2016-12, Narrow Scope Improvements and Practical Expedients
- ASU 2016-20, Technical Corrections and Improvements to ASC 606, Revenue from Contracts with Customers
Applies to all contracts with customers, except for contracts that are within the scope of other standards:
- Lease contracts (ASC 840)
- Insurance contracts (ASC 944)
- Financial instruments and other contractual rights or obligations (ASC 310, 320, 323, 325, 405, 470, 815, 825, & 860)
- Certain non-monetary exchanges
- First interim period within annual reporting periods beginning after December 15, 2017.
- Annual reporting periods beginning after December 15, 2018 and interim periods within annual periods beginning after December 15,
- Permitted for all entities but no earlier than periods beginning after December 15, 2016.
ASC 606 is required to be applied using one of the following methods:
- Retrospective application to each reporting period presented in accordance with ASC 250, Accounting Changes and Error Corrections or IAS 8, Accounting Policies, Changes in Accounting Estimates and
- Modified retrospective by means of recognizing a cumulative effect of initially applying the standard as an adjustment to the opening balance of retained earnings in the period of The following practical expedients can also be elected:
- Need not restate contracts that begin and are completed with the same annual reporting period
- For completed contracts that have variable consideration, may use transaction price at the date the contract was completed
- For reporting period prior to the date of initial application, need not disclose the amount of transaction price allocated to the remaining performance obligations and related explanation
- Need not restate modified contracts that were modified before the beginning of the earliest reporting period presented
An agreement between two or more parties that creates enforceable rights and obligations.
A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.
US GAAP – Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
IFRS – Revenue as income arising in the course of an entity’s ordinary activities.
A good or service that is promised to a customer that meets both the following criteria:
- 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.
- The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.
Standalone selling price:
The price at which an entity would sell a promised good or service separately to a customer.
A promise to transfer to the customer either:
- A distinct (bundle of) good(s) or service(s)
- A series of substantially the same distinct goods or services that have the same pattern of transfer to the customer, and the pattern of transfer is both over time and represents the progress towards complete satisfaction of the performance
The ‘Five Step’ Model
Revenue from contracts with customers is recognized based on the application of a principle-based ‘five step’ model:
IDENTIFY, DETERMINE, ALLOCATE, RECOGNIZE
Step 1: IDENTIFY the contract
Step 2: IDENTIFY the performance obligation(s)
Step 3: DETERMINE the transaction price
Step 4: ALLOCATE the transaction price to each performance obligation
Step 5: RECOGNIZE revenue as each performance obligation is satisfied
Step 1: Identify the Contract
Features of a ‘contract’ under ASC 606
Contracts, and approval of contracts, can be written, oral or implied by an entity’s customary business practices.
ASC 606 requires contracts to have all of the following attributes:
- The contract has been approved and the parties are committed to perform their respective obligations
- The rights and payment terms regarding goods and services to be transferred can be identified
- The contract has commercial substance
- It is probable substantially all of the consideration that the vendor is entitled to will be collected (considering only the customer’s ability and intention to pay)
If each party to the contract has a unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties), no contract exists under ASC 606.
Combining multiple contracts
Contracts are combined if they are entered into at (or near) the same time, with the same customer, if any of the following criteria are met:
- The contracts are negotiated as a package with a single commercial objective;
- The consideration to be paid in one contract depends on the price or performance of another; or
- The overall goods or services of the contracts represent a single performance
A change in enforceable rights and obligations (i.e. scope and/or price) is only accounted for as a contract modification if it has been approved, and creates new or changes existing enforceable rights and obligations.
Contract modifications are accounted for as a separate contract if, and only if:
- The contract scope changes due to the addition of distinct goods and services, and
- The change in contract price reflects the standalone selling price of the distinct good or
Contract modifications that are not accounted for as a separate contract are accounted for as either:
- Replacement of the original contract with a new contract (if the remaining goods and services under the original contract are distinct from those already transferred to the customer).
- Continuation of the original contract (if the remaining goods and services under the original contract are distinct from those already transferred to the customer, and the performance obligation is partially satisfied at modification date).
Step 2: Identify the Performance Obligation
What is a performance obligation?
A performance obligation is the contractual promise by an entity, to transfer to a customer, distinct goods or services, either individually, in a bundle, or as a series over time.
Activities of the entity that do not result in a transfer of goods or services to the customer (e.g. certain internal administrative ‘set-up’ activities) are not performance obligations in the contract with the customer and do not give rise to revenue.
Definition of ‘Distinct’ (two criteria to be met)
1. The customer can ‘benefit’ from the good or service
Benefit from the good or service can be through either:
- Use, consumption, or sale (but not as scrap), or
- Held in a way to generate economic benefits. Benefit from the good or service can be either:
- On its own, or
- Together with other readily available resources (i.e. those which can be acquired by the customer from the entity or other parties).
2. The promise to transfer a good or service is separable from other promises in the contract
The assessment requires judgment, and consideration of all relevant facts and circumstances. A good or service may not be separable from other promised goods or services in the contract, if:
- There are significant integration services with other promised goods or services;
- It modifies/customizes other promised goods or services; and
- It is highly dependent/interrelated with other promised goods or services.
Step 3: Determine the Transaction Price
What is the transaction price?
The transaction price is the amount of consideration an entity expects to be entitled to in exchange for transferring the promised goods or services. The transaction price is allocated to previously identified performance obligation(s) and ultimately is the amount of revenue recognized as those identified performance obligations are satisfied. An accounting policy election is available to exclude amounts collected from customers for all sales (and other similar) taxes from the transaction price. Otherwise, an entity must determine whether such amounts should be included or not.
The transaction price may be effected by the nature, timing, and amount of consideration, and includes consideration of significant financing components, variable components, amounts payable to the customer (e.g. refunds and rebates), and non- cash amounts.
Accounting for variable consideration
Examples of variable consideration include discounts, rebates, refunds, credits, concessions, incentives, performance bonuses, penalties, and contingent payments. Variable consideration must be estimated using either:
- Expected value method: based on the sum of probability-weighted amounts within a range of possible consideration amounts (i.e. for large number of similar contracts).
- Most likely amount: the single most likely amount within a range of possible consideration amounts (i.e. where there are few outcomes to consider).
Constraining (limiting) the estimate of variable consideration
- Variable consideration is only recognized if it is probable that a subsequent change in the estimate would not result in a significant revenue reversal (i.e. a significant reduction in cumulative revenue recognized).
Accounting for a significant financing component
Required if the timing of payments provides either the customer or the entity with a significant benefit of financing the transfer of goods or services. The transaction price is adjusted to reflect the cash selling price at the point in time control of the goods or services is transferred.
A significant financing component can either be explicit or implicit. Factors to consider include:
- Difference between the consideration and cash selling price
- Combined effect of interest rates and length of time between transfer of control of the goods and services and payment
A significant financing component does not exist when:
- Timing of the transfer of control of the goods or services is at the customer’s discretion
- The consideration is variable with the amount or timing based on factors outside of the control of the parties
- The difference between the consideration and cash selling price arises for other non- financing reasons (i.e. performance protection)
Discount rate to be used
- Must reflect credit characteristics of the party receiving the financing and any collateral/security provided
Practical expedient – period between transfer and payment is 12 months or less
- Do not account for any significant financing
Accounting for consideration payable to the customer
Includes cash paid (or expected to be paid) to the customer (or the customer’s customers) as well as credits or other items such as coupons and vouchers. Accounted for as a reduction in the transaction price, unless payment is in exchange for a distinct good or service received from the customer in which case no adjustment is made – except where:
- The consideration paid exceeds the fair value of the goods or services received (the difference is set against the transaction price)
- The fair value of the goods or services cannot be reliably determined (full amount taken against the transaction price)
Accounting for non-cash consideration
Includes receipt of goods, services, or equity instruments from a customer. Usually measured at fair value at contract inception.
Step 4: Allocate the Transaction Price to Each Performance Obligation
The transaction price (Step 3) is allocated to each performance obligation (Step 2) based on the stand-alone selling price of each performance obligation. If the stand-alone selling price(s) is/are not observable, it is estimated, maximizing the use of observable inputs.
Approaches to estimate may include:
Adjusted market assessment approach
- Expected cost plus a margin approach
- Residual approach (i.e. residual after observable stand-alone selling prices of other performance obligations have been deducted)
Note that restrictive criteria must be met for approach (iii) to be applied.
Allocating variable consideration
Variable consideration is allocated entirely to a performance obligation (or a distinct good or service within a performance obligation), if both:
- The terms of the variable consideration relate specifically to satisfying the performance obligation (or transferring the distinct good or service within the performance obligation); and
- The allocation of the variable consideration is consistent with the principle that the transaction price is allocated based on what the entity expects to receive for satisfying the performance obligation (or transferring the distinct good or service within the performance obligation).
Allocating a ‘discount’
A discount exists where the sum of the stand-alone selling prices of all performance obligations exceeds the consideration payable. Discounts are allocated on a proportionate basis, unless there is observable evidence that the discount relates to one or more specific performance obligation(s) after meeting all of the following criteria:
- The goods or services (or bundle thereof) in the performance obligation are regularly sold on a stand-alone basis, and at a discount; and
- The discount is substantially the same in amount to the discount that would be given on a stand-alone basis.
Step 5: Recognize Revenue as Each Performance Obligation is Satisfied
The transaction price allocated to each performance obligation (Step 4) is recognized as/when the performance obligation is satisfied, either:
- Over time, or
- At a point in
Satisfaction occurs when control of the promised good or service is transferred to the customer:
- Ability to direct the use of the asset
- Ability to obtain substantially all the remaining benefits from the asset
Factors to consider when assessing transfer of control:
- Entity has present right to payment for the asset
- Entity has physically transferred the asset
- Legal title of the asset
- Risks and rewards of ownership
- Acceptance of the asset by the customer
Recognizing Revenue Over Time (applies if any of the following three criteria are met)
1. Customer simultaneously receives and consumes all of the benefits
E.g. many recurring service contracts (such as cleaning services). If another entity would not need to substantially re-perform the work already performed by the entity in order to satisfy the performance obligation, the customer is considered to be simultaneously receiving and consuming benefits.
2. The entity’s work creates or enhances an asset controlled by the customer
The asset being created or enhanced (e.g. a work in progress asset) could be tangible or intangible.
3. 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.
Assessment requires judgment and consideration of all facts and circumstances. An asset does not have an alternate use if the entity cannot practically or contractually redirect the asset to another customer:
- Significant economic loss, e. through rework, or reduced sale price (practical)
- Enforceable rights held by the customer to prohibit redirection of the asset (contractual)
Whether or not the asset is largely interchangeable with other assets produced by the entity should also be considered in determining whether practical or contractual limitations occur.
Enforceable right to payment
Consider both the specific contractual terms and any applicable laws or regulations. Ultimately, other than due to its own failure to perform as promised, an entity must be entitled to compensation that approximates the selling price of the goods or services transferred to date. The profit margin does not need to equal the profit margin expected if the contract was fulfilled as promised. For example, it could be a proportion of the expected profit margin that reflects performance to date.
Revenue that is recognized over time is recognized in a way that depicts the entity’s performance in transferring control of goods or services to customers. Methods include:
- Output methods: (e.g. Surveys of performance completed to date, appraisals of results achieved, milestones reached, units produced/delivered, ).
- Input methods: (e.g. Resources consumed, labor hours, costs incurred, time lapsed, machine hours, etc.), excluding costs that do not represent the seller’s
Recognizing Revenue at a Point in Time
Revenue is recognized at a point in time if the criteria for recognizing revenue over time are not met. Revenue is recognized at the point in time at which the entity transfers control of the asset to the customer (see adjacent box).
Application Guidance with ASC 606
ASC 606 contains application guidance for:
- Contract costs
- Sale with a right of return
- Principal versus agent considerations
- Customer options for additional goods or services
- Customers’ unexercised rights
- Non-refundable upfront fees (and some related costs)
- Repurchase agreements
- Consignment arrangements
- Bill-and-hold arrangements
- Customer acceptance
A summary is set out below for the items in bold.
Contract costs (Subtopic 340-40)
Costs of obtaining a contract that are incremental and expected to be recovered are recognized as an asset. If costs to fulfill a contract are within the scope of other Topics (e.g. ASC 330, 350, 360, etc.) apply those Topics. If not, a contract asset is recognized under Subtopic 340-40 if, and only if, the costs:
- Are specifically identifiable and directly relate to the contract (e.g. direct labor, materials, overhead allocations, other unavoidable costs (e.g. sub- contractors));
- Create (or enhance) resources of the entity that will be used to satisfy performance obligation(s) in the future; and
- Are expected to be recovered.
Costs that are recognized as an expense as incurred
- General and administrative expenses
- Wastage, scrap, and other (unanticipated) costs not incorporated into pricing the contract
- Costs related to (or can’t be distinguished from) past performance obligations
Amortization and impairment of contract assets
- Amortization is based on a systematic basis consistent with the pattern of transfer of the goods or services to which the asset
- Impairment exists where the contract carrying amount is greater than the remaining consideration receivable, less directly related costs to be
Warranties (fall into either one of two categories):
- Assurance type (apply Subtopic 460-10):
- An assurance to the customer that the good or service will function as specified
- The customer cannot purchase this warranty separately from the entity
- Service type (accounted for separately in accordance with ASC606):
- A service is provided in addition to an assurance to the customer that the good or service will function as specified
- This applies regardless of whether the customer is able to purchase this warranty separately from the entity
In determining the classification (or part thereof) of a warranty, an entity considers:
- Legal requirements: (warranties required by law are usually assurance type)
- Length: (longer the length of coverage, more likely additional services are being provided)
- Nature of tasks: (do they provide a service or are they related to assurance? (e.g. return shipping for defective goods))
Licensing (of an entity’s intellectual property (IP)
- If the license is not distinct from other goods or services
- It is accounted for together with other promised goods and services as a single performance obligation
- A license is not distinct if either:
- It is an integral component to the functionality of a tangible good; or
- The customer can only benefit from the license in conjunction with a related service.
- If the license is distinct from other goods or services
- It is accounted for as a single performance
- Revenue is recognized either at a point in time, or over time, depending on whether the nature of the vendor’s promise in transferring the license to the customer is to provide customer with either:
- A right to access the vendor’s IP throughout the license period (i.e., the vendor continues to be involved with its IP); or
- A right to use the vendor’s IP as it exists at the point in time the license is
To determine whether the promise represents a right to access the vendor’s IP or a right to use the vendor’s IP, consider the nature of the IP by categorizing the underlying license as either functional or symbolic.
- A functional license has significant standalone functionality because it can be used as is for performing a specific task, or be aired or
- A symbolic license does not have significant standalone functionality. It represents a promise to both (a) grant the customer rights to use and benefit from the intellectual property and (b) support or maintain the intellectual property during the license period (or over the remaining economic life, if shorter).
Non-refundable upfront fees
Includes additional fees charged at (or near) the inception of the contract (e.g. joining fees, activation fees, set-up fees etc.). Treatment dependents on whether the fee relates to the transfer of goods or services to the customer (i.e. a performance obligation under the contract):
- Yes: Recognize revenue in accordance with ASC 606 (as or when goods or services transferred)
- No: Treated as an advance payment for the performance obligations to be fulfilled
(Note: Revenue recognition period may in some cases be longer than the contractual period if the customer has a right to, and is reasonably expected to, extend/renew the contract).
Overall objective: to disclose sufficient information to enable users to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from an entity’s contracts with customers.
Contracts with customers (information regarding):
- Disaggregation of revenue
- Contract assets and contract liabilities
- Performance obligations (including remaining)
Use of practical expedients (related to):
- Significant financing component (greater than 12-months)
- Contract costs (amortization period greater than 12-months)
- Performance obligation satisfaction
- Transaction price (including allocation)
- Determining contract costs capitalized
Contract costs capitalized:
- Method of amortization
- Closing balances by asset type
- Amortization and impairment
Statement of financial position
- Contract assets and contract liabilities from customers are presented separately
- Unconditional rights to consideration are presented separately as receivables
Statement of profit or loss and comprehensive income
- Line items (revenue and impairment) are presented separately in accordance with the requirements of ASC 205,
Presentation of Financial Statements.
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