How to handle key revenue recognition changes (ASC 606)
The Financial Accounting Standards Board’s (FASB’s) new revenue recognition standard, ASC 606, is now in effect for private companies with annual reporting periods beginning after December 15, 2018.
While many professional service companies have completed their analyses and made updates to track their data to the new standard, some are still playing catch-up. Those companies need to determine how they’ll manage the five steps to recognizing revenue from contracts with customers, namely:
- How to identify performance obligations in a contract
- How to account for variable consideration
- When to recognize revenue (over time or at a point in time)
- Which methods to use to recognize revenue over time
- How to account for contract modifications
Identifying performance obligations in a contract
Identifying performance obligations in a contract is a critical step because it impacts revenue amounts and timing. ASU 606 defines a performance obligation as “a promise to provide a good or service to a customer.” The promise can be explicitly stated, implicit or assumed based on customary business practices. Performance obligations must be either a distinct good/service or a series of distinct goods/services that are materially the same and have the same pattern of transfer to the customer.
Just because a good or service is capable of being distinct, doesn’t mean that it’s distinct in the context of the contract. If goods and services within the contract are highly interrelated with other goods or services, then they may not be distinct within the context of the contract.
Example of a performance obligation
An example of a service not being distinct within a contract could be engineering services performed during the design and construction phase of a project. While these services may be sold on a standalone basis, if a contract is written so the services are fluid throughout the design and construction period, the two services may be considered one performance obligation. Each contract must be evaluated separately to make these determinations.
Accounting for variable consideration
Professional service companies often issue discounts, rebates, refunds, price concessions, incentives, performance bonuses, penalties and other price modifications. Such variability can be explicitly stated in the contract, or it can be implied through customer business, industry practices or other means.
ASC 606 requires companies to estimate the impact of the expected variability in the transaction price and allocate it to the performance obligations so it is recognized as revenue. This differs from current U.S. GAAP, which would not have a company record variable consideration until the contingency is resolved.
In the new standard, variable consideration can be estimated two ways:
- The expected value method is the sum of the probability-weighted amounts in a range of possible outcomes.
- The most likely amount method uses the most likely outcome of the contract. This method is best suited when there are only two possible outcomes (e.g., a company finishes ahead of schedule and receives a performance bonus, or it does not).
Companies need to apply the method that is the best estimate of the variable consideration depending on the facts and circumstances.
Revenue recognition: Over time or at a point in time
Performance obligations are satisfied and revenue can be recognized when a customer obtains control of the asset or benefits from the services provided. That can occur at a point in time or over a period of time, depending on certain facts.
At a point in time: For a point in time, the performance obligation is satisfied and revenue is recognized when control of the good or service is transferred to the customer.
Over a period of time: A performance obligation is satisfied and revenue is recognized over time if any of the following are met:
- The customer receives and consumes the benefits of the goods or services as they are provided by the entity (e.g., routine, recurring services like cleaning services that are substantially the same and have the same pattern of transfer).
- The goods or services create or enhance an asset the customer controls as that asset is created or enhanced (e.g., contractors who renovate a home owned by the customer or build a structure on land owned by the customer).
- The asset created does not have an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date (e.g., custom design services or construction of a custom product to customer specifications). An enforceable right to payment for performance completed to date should include the right to costs incurred to date and a reasonable profit margin.
When a performance obligation is met and revenue is recognized over time, it is similar to “percentage of completion.” The primary difference is that revenue is intended to be recognized in a pattern that represents the transfer of control to the customer.
Methods to recognize revenue over time
Control transfer progress can be measured using one of the two acceptable methods:
- Output method: Revenue is recognized based on the value transferred to the customer relative to the remaining value to be transferred. Some examples would be surveys of performance completed to date, appraisals of results, milestones reached, time elapsed and units produced.
- Input method: Revenue is recognized based on the entity’s effort to satisfy the performance obligation, relative to the total expected effort to satisfy the performance obligation. Some examples are resources consumed, labor hours expended, costs incurred, time elapsed and machine hours used.
The input method has to carefully consider if the inputs truly measure progress to completion. For example, materials may be purchased and recorded as inputs to the project, but due to uninstalled materials, the full amount may not properly depict progress. Similarly, if a company uses time inputs to track progress, ineffective time incurred related to the contract that does not affect progress must be expensed as incurred rather than used to estimate the project’s status.
Accounting for contract modifications
A contract modification is an approved change in the scope and/or price of a contract. It could be a formal contract amendment or a simple change order. Depending on the circumstances, these modifications may be treated as a separate contract or part of the existing contract. Or, you could terminate the existing contract and create a new one.
If the scope of the goods or services outlined in the contract modification are distinct and at a standalone selling price, then the modification is treated as a separate contract.
The determining distinction is within the context of the contract. If the contract is not deemed a separate contract but the goods or services are distinct, then the modification is treated as a termination of the existing contract and a new contract should be issued. If the contract modification is not a separate contract and does not have distinct goods or services, it is treated as part of the existing contract. A combination of these treatments may also be required.
One more example: An engineering company with an overall electrical engineering contract may have a change order executed for an additional electric component. If the additional component is integrated with the electrical component outlined in the initial contract, it is likely that the modification would be considered part of the existing contract. The company could use a cumulative catch-up adjustment to increase or decrease revenue, if necessary, to account for the additional contract component.
It’s imperative that companies address these considerations and others within ASC 606 to help ensure that all required adjustments have been identified. At a minimum, professional service companies will need to meet the new, more detailed disclosure requirements of the standard.
Another viable option: Financial reporting framework for small- and medium-sized entities
Nonpublic professional service companies must also determine if U.S. GAAP is still the best reporting framework for them. With the complexity of the revenue recognition standard, and significant changes to the leasing standard in the following year, some organizations are considering other financial reporting frameworks that are more relevant to their businesses.
In 2013, the American Institute of CPAs introduced the Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs). FRF for SMEs is a special purpose framework based on the principles of GAAP but tailored to the needs of privately held businesses and their financial statement users. This framework follows traditional GAAP accounting for revenue transactions and leases.
When reviewing the effects of the new revenue and leasing standards, management may determine that financial statement users would be negatively impacted by the required updates, or that the cost of implementing the changes far exceeds the benefit. If either is the case, take a closer look at the FRF for SMEs framework as a reporting alternative.
While FRF for SMEs is not the same as GAAP, there are minimal differences between the two frameworks for everyday accounting issues. And the level of assurance is the same for both reporting options. If a company obtained an audit for an FRF for SMEs financial statement, the relevant auditing procedures and opinion would provide the same assurance as a GAAP financial statement audit. In addition, FRF for SMEs is very similar to traditional GAAP for most transactions that affect privately held companies. It can be an excellent solution for companies that don’t need U.S. GAAP financial statements.
How Wipfli can help
Our tax specialists have helped clients successfully adopt ASC 606 and FRF for SMEs. It’s our job to educate you about the frameworks so you can make the best decision for your stakeholders and plan the smoothest transition possible. If you need help selecting or implementing a revenue recognition standard, we can get you on the right track. To get started, contact us today.
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