New rules are coming out for how to recognize revenue from contracts. For public entities, they will take effect for fiscal years starting after December 15, 2017, and other entities will have an extra year – they will start in fiscal years beginning after December 15, 2018. The new rules have a 5-part process; I went into detail for the first 3 last week, and will cover 4 and 5 this week, as well as disclosures to include in your financial statements.
So far, your organization has (1) identified a contract with a customer, (2) identified the performance obligations in the contract, and (3) determined the transaction price of the contract. The remaining steps are to (4) allocate the transaction price to the performance obligations, and (5) recognize revenue when, or as, you satisfy a performance obligation.
If the contract only has one performance obligation, step 4 is already done. If there are multiple obligations, what price would you sell each one for, individually? The clearest indication of a standalone price is what you’ve charged other customers for the same item, in similar circumstances. Otherwise, you’ll have to estimate it based on market conditions and other relevant factors. In cases where you have to make estimates, use consistent methods in similar circumstances. Pages 13 and 14 from this resource from the AICPA give examples of methods you can use.
If the contract includes discounts or other variable consideration, are they specific to one or more individual obligations, or a general discount for the contract as a whole? If a discount is specific to one performance obligation, it will reduce the price of that obligation. Otherwise, apply it proportionally as you recognize revenue, based on the relative standalone price of each performance obligation.
In the event that the transaction price changes over the life of the contract, apply the change to performance obligations in the same way you would apply discounts and variable consideration. For performance obligations that have been satisfied, you’ve already recognized the revenue, so any changes to the price of these obligations should be recognized as an increase or decrease to revenue, in the period in which the transaction price changes.
Revenue is recognized when, or as, you satisfy performance obligations. Some obligations will be met at a point in time, such as when you complete an asset and transfer control of it to your customer. In these cases, recognize all of the revenue at once. Other obligations are met over the course of time, such as a contract for cleaning services, or a licensing agreement. Revenue is then recognized over the course of the contract, based on either output methods or input methods. Output methods measure the value you’ve delivered to your customer (e.g. surveying performance completed to date, reaching milestones, the amount of time elapsed, the number of units produced or delivered) while input methods measure your efforts or inputs into meeting performance obligations (e.g. resources consumed, labor hours expended, costs incurred, machine hours used). Use the method that most faithfully measures the delivery of goods or services to your customer.
Aside from recognizing revenue, there FASB standard requires certain disclosures in your financial statements. Include quantitative and qualitative information about:
- Disaggregation of revenue. Show how economic factors may affect the nature, amount, timing, and uncertainty of cash flows.
- Contract balances. Include starting and ending balances of receivables, assets and liabilities related to your contracts, as well as revenue recognized in the current period that’s included in the liability balance and/or for performance obligations fully or partly satisfied in previous periods.
- Performance obligations. Disclose when you satisfy performance obligations; payment terms; the nature of the goods and services you are transferring to your customers; obligations for returns, refunds, and warranties; the transaction price allocated to remaining performance allocations, and when you expect to recognize the remaining revenue.
- Significant judgments and estimates. Disclose any significant judgments you used in applying the revenue recognition standard, such as whether you recognize revenue for a contract at a point in time or over a period of time, estimates of the transaction price, and how you allocated it to performance obligations.
With the changeover to the new standard, it’s best to plan ahead for how it will impact you and how you’ll implement it. The AICPA has provided this resource for implementation planning and the Journal of Accountancy has also published some tips for the process. I’ve also referenced this brief from the AICPA that goes into much greater detail than I’ve used in my blog posts (note: it’s fairly technical), as well as articles here and here from the Journal of Accountancy.