One of the hottest accounting topics today is the new revenue recognition standard (ASC 606). The standard has been in effect for calendar-year public companies since January 1, 2018 and for private calendar-year clients since January 1, 2019. So, by now you should be familiar with the five-step process to determine how to recognize and present revenue.
But maybe you have been procrastinating? Or believe you will not be affected? If you are involved in the financial reporting of an organization with customer contracts, the below items will undoubtably be relevant to your organization.
What follows are five ways that your company’s financial reporting will be affected even if there is no change in your revenue recognition.
First, ASC 606 uses new vocabulary for revenue recognition. In order to analyze your company’s situation and prepare the required disclosures (see #3 below) you will need to become familiar with new terms, or expanded meanings for existing terms, including the following:
- Performance Obligation: A promise in a contract with a customer to transfer either a good, a service or a bundle that is distinct.
- Contract Asset: An entity’s right to consideration from a customer that is conditioned on something other than the passage of time.
- Contract Liability: An entity’s obligation to transfer goods or services to a customer for which the entity has received consideration from the customer.
- Variable Consideration: Consideration such as discounts or refunds and/or consideration that is contingent on a future event occurring.
- Material Right: An option offered to a customer for entering into a contract that is more beneficial than the stand-alone price for the option.
- Functional IP License: A license to intellectual property that has significant standalone functionality — such as software or a drug formula.
- Symbolic IP License: A license to intellectual property that does not have a significant standalone functionality — such as trade names or logos.
2. Distinguishing Revenue
Second, you will need to differentiate your revenues by revenue that is recognized at a point in time or recognized over time.
Revenue is required to be recognized over time if it meets one of the following criteria:
- The customer simultaneously receives and consumes the benefits provided as the entity performs. This is the case for routine or recurring services, such as a cleaning service.
- The entity’s performance creates or enhances an asset (for example, work in process) 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 (such as specialized or proprietary products), and the entity has an enforceable right to payment for performance completed to date.
Revenue is recognized at a point in time if it doesn’t meet any of the three criteria for recognizing revenue over time.
3. Expanded Disclosures
Next, you will have expanded disclosures. Prior to ASC 606, generally accepted accounting principles (GAAP) required very minimal disclosures for revenue — and only for certain industry or organizational situations. ASC 606 requires significant disclosures for all entities regardless of the industry or type of revenue. Even if there will be no change in the amount or timing of revenue recognition, you will need to draft additional disclosures.
Here is a few of the disclosures that are required for all entities:
- Disclose revenue recognized from contracts with customers disaggregated between revenue recognized at a point in time and revenue recognized over time (see #2 above).
- Disclose opening and closing balances of accounts receivable, contract assets and contract liabilities related to revenue from contracts with customers for all years presented.
- Disclose performance obligations and when they are typically satisfied.
- Disclose significant payment terms.
- Disclose obligations for returns, refunds and other similar obligations.
- Disclose judgments used in determining the timing of revenue recognition and the transaction price and allocation practices.
The days of having a one-paragraph summary of your revenue recognition policy are gone. Many larger, complex entities are experiencing three to five pages of disclosures in their financials; however, even the simplest entities are still seeing close to a full page of added disclosures.
4. Analyzing Contracts
Fourth is the need to analyze an entity’s contracts. Step one in ASC 606 is to identify the contract and determine if it meets the requirements of ASC 606. Before any revenue can be recognized, you need to determine if you have a contract under ASC 606.
A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. The contract may be written or oral, contain standard terms and conditions, or be implied by customary business contracts.
Before moving to step two of ASC 606, you must determine that all of the following contract 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 substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer
While it may seem straight-forward to assess, there are a few twists in the analysis of a contract.
For example, for purposes of ASC 606, a contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties). Therefore, cancellation provisions should be read carefully.
If a contract with a customer does not meet the above criteria, no revenue is recognized until the contract does meet the conditions or until the contract is wholly performed and consideration has been received, control has passed to the customer and no remaining performance obligations exist.
ASC 606 also details the method of recognizing contract modifications and renewals.
In addition, all discounts, special offers, rebates, refunds, return options and warranties contained in the contract must be analyzed and accounted for in accordance with ASC 606.
Based on these factors, it will be beneficial to you to reassess your standard contract wording to avoid unwanted surprises on the back end, such as not being able to recognize revenue until you receive final payment.
5. Recognizing Contract Costs
Finally, there may be changes in recognizing contract costs. ASC 606, through changes to specific subtopics, differentiates contract costs by those that are incurred to obtain a contract and those to fulfill a contract.
Costs to obtain a contract, such as commission expense, are costs that would not be incurred if the contract was not obtained. These incremental costs should be capitalized and expensed over the contract period.
Costs to fulfill a contract should be capitalized if the following are met:
- The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (for example, costs relating to services to be provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved).
- The costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future.
- The costs are expected to be recovered.
So how did you do? Any surprises? ASC 606 is very comprehensive and typically requires a significant amount of analysis and thought to ensure an entity is complying with all aspects of the standard. If you would like to discuss your entity’s specific situation or have any questions on ASC 606, please reach out to your Wipfli team. We are ready and waiting to help you!