Five steps to revenue recognition - Part 1
August 9, 2017
By Steve Campana, CPA, ABV, CFF®
As a reminder:
Public Companies are effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period.
Applies to all other entities for annual reporting periods beginning after December 15, 2018.
The words embedded in my head when studying for the CPA examination many years ago were, “revenue is recognized when an exchange has taken place and the earnings process is complete.” Additionally, guidance was then often made available at the industry level for the application of this framework within the context of transactions typically occurring in that industry. For example:
- AICPA Accounting Research Bulletin (ARB) No. 45, Long-Term Construction-Type Contracts, (1955) and
- AICPA Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (1981)
The new Revenue Recognition Standard requires companies to recognize revenue:
- When promised goods or services are transferred to customers
- In the amount of consideration to which the company expects to be entitled
Feels a lot like when an exchange has taken place and the earnings process is complete, doesn’t it? The new standard has outlined a five-step process, of which the first three outline the steps that should be taken prior to an engagement with a customer.
Step 1: Identify the contract with a customer
A contract is an agreement that creates enforceable rights and obligations to which the parties are committed as a matter of law. A contract may be written, oral or implied by the entity’s customary business practices. A contract must meet the following criteria:
- Parties have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations
- Each party’s rights regarding the goods or services to be transferred are identified and the parties plan to enforce their rights
- The payment terms for the goods or services to be transferred are identified
- The contract has commercial substance (that is, the risk, timing or amount of the seller’s future cash flows is expected to change as a result of the contract)
- It is probable the seller will collect the consideration entitled in exchange for the goods or services that will be transferred to the customer (collectability threshold)
Step 2: Identify performance obligations
The Revenue Recognition Standard defines a performance obligation as a promise in a contract with a customer to transfer a good or service to the customer.
At contract inception, an entity should assess the goods or services promised in a contract with a customer and should identify as a performance obligation (there could be multiple performance obligations) each promise to transfer to the customer either:
- A good or service (or 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
A good or service that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct. In many cases, that will result in the entity accounting for all the goods and services promised in a contract as a single performance obligation.
A good or service is distinct if both of the following criteria are met:
- Capable of being distinct – The customer can benefit for the good or service on its own or together with other resources that are readily available to the customer.
- Can be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits
- Either on its own or in conjunction with other readily available resources
- Distinct within the context of the contract – The entity’s promise to transfer the goods or services is separately identifiable from other promises in the contract.
- No need to integrate the good or service with other goods or services
- No significant modifications or customizationsNot highly dependent on, or highly interrelated with, other goods or services
For purposes of illustration, assume an alarm company installs a security system which has prices for materials and labor and also provides for monitoring services for five years as part of the contract. This example would most likely lead to the conclusion that there are two distinct performance obligations within the contract: One for materials and labor to install the system, and the other for ongoing monitoring.
Likewise, assume a construction contract that includes razing an old building, site-work, new building construction, landscaping etc.: These services are interrelated with their combined output being a new building. The individual activities are not considered distinct within the context of the entire contract, and therefore there would be only a single performance obligation identified.
Step 3: Determine the transaction price
An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts or both.
To determine the transaction price, the entity must consider the effects of:
- Variable consideration
- Constraining estimates of variable consideration
- The existence of a significant financing component
- Noncash considerations, and
- Consideration payable to the customer
Determining the transaction price in the construction industry, in many cases, may require considerable effort. Variable consideration might include such things as performance bonuses, unpriced or unsigned change orders, claims and liquidated damages, and non-cash consideration.
Companies will need to estimate the amount of variable consideration to include in the contract’s transaction price using one of two methods:
- The single, most-likely amount
- The probability-weighted expected value
In addition, there is a constraint on the amount of variable consideration that should be included in the transaction price. The objective of the constraint states that an entity shall include an estimate of variable consideration in the transaction price to the extent that it is probable a significant revenue reversal will not occur.
Discounting is required if the contract has a significant financing component which will likely require the recording of a loan as part of the arrangement with interest to be considered and reported separately. Discounting would not be required if it is likely that it will be less than a year between payment and performance.
Let’s assume two contracts: The first is for $5,000,000 with a $250,000 performance bonus if completed by a second date. The second contract is the same facts as above, but the performance bonus has a clause that states the bonus is $250,000 if completed by the agreed upon date, reduced by 10% per week for every week beyond the agreed-upon completion date.
In the first contract, the result is binary, either yes or no, either met or not met, and if it is probable the agreed-upon completion date target will be met and therefore the performance bonus will be earned, then the single most-likely amount method with a transaction price of $5,250,000 would be used.
In the case of the second contract, let’s assume a normal probability distribution across the ten weeks. That is, each week of the ten-week period has an equal probability of being the outcome. Then, in this case, the probability-weighted expected value method should be used resulting in a transaction price of $5,137,500.
The next two steps will cover allocation of transaction price to obligations and recognizing revenue when the obligation has been met. Construction contractors and the users of their financial statements should work with their CPA to navigate the complexities of this implementation process.
For more information or assistance on preparing for the new revenue recognition standard, call 888-556-0123, email email@example.com or submit our online form.