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Article Author:

Proposed Changes to Revenue Recognition Standards — Only One Proud Standard Rather than Dozens

What’s “ahead” in this article:

> Key Points
> FAQs — Other Common Questions and Answers
> Suggested Next Steps
> A Final Important Note

(click on these links to go directly to that section)

The Financial Accounting Standards Board (FASB) issued an exposure draft in June 2010 to create a single, comprehensive standard for revenue from contracts with customers, replacing the many standards that currently exist in US GAAP; however, its effective date has not yet been set.

Most entities will be affected by this proposed standard - however, some types of entities, such as those listed below, may feel it more than most.

• Entities that do business under longer-term contracts
• Technology firms
• Entities that have licensing arrangements with their customers
• Entities that have customers with known higher credit risk

Key Points

• There are five steps in the proposed revenue recognition model, each one having potential complexities: 

1. Identify the contract with the customer. 
2. Identity the separate performance obligations in the contract. 
3. Determine the transaction price. 
4. Allocate the transaction price to the separate performance obligations. 
5. Recognize revenue when each separate performance obligation is satisfied. 

Let's look at some aspects of these five steps . . . .

• Contracts with customers don't have to be written.

All that is needed is an enforceable obligation.

• Multiple contracts with a customer may be accounted for as one contract, or a single contract with a customer may be segmented into multiple contracts.

If the pricing of the multiple contracts is deemed to be interdependent, then the accounting would reflect a single contract.

If goods or services covered by a single contract are priced independently, the single contracts would be segmented into multiple contracts.

There has been some worry about too many segments coming out of this step, resulting in a lot more accounting work.

And if you want to do even more contract analysis, read on . . . .

• A contract may be one performance obligation or multiple performance obligations.

Once you have defined the contract from the preceding step, then another breakdown must be considered under the proposed standard.

The revenues for separate performance obligations will be accounted for separately. Individual goods and services are to be accounted for separately if they are "distinct." A good or service is "distinct" if somebody sells it separately OR it could be sold separately because it has both a distinct function and profit margin.

There has been some "distinct" howling over this aspect of the proposed standard - some constituents feel there may be too many performance obligations identified, resulting in cost/benefit considerations or in a lack of proper representation of the contract itself.

Some further drilldown on warranties as performance obligations (or not) . . . .

• Warranties for defects at time of transfer.

Revenue for sales of goods with warranty for defects at time of transfer would be recorded net of cost of replacement or repair. These sorts of warranties are not considered to be a separate performance obligation, as the customer ordered, for instance, 100 units of Product A in good working order.

As contrasted with . . . .

• Extended warranties.

Extended warranties are generally considered to be a separate performance obligation. Therefore a portion of the transaction price is allocated to them.

The differing accounting for the two types of warranties may be difficult to apply in practice, in terms of deciding if a defect existed at the time of transfer or if it subsequently developed.

• Revenue is recorded at the probability-weighted amount expected to be received.

Factors to consider when determining the transaction price:

• Estimates of variable consideration
• Customer's credit risk
• Time value of money
• Fair value of noncash consideration
• Consideration payable to customer

We'll just focus on a couple of these -

If the transaction price can vary because of contract terms such as an incentive payment, the entity is to record the initial measurement of revenue at the probability-weighted amount. This includes the consideration of the customer's credit risk.

The variable price is re-evaluated each period, with adjustments recorded as necessary. This re-evaluation may add a significant amount of time to the closing process.

Let's say an entity is to receive an incentive payment of $100,000 if a project is completed by a certain date, and $0 if it is not. If the probability of completing that project on time is 80%, then the entity would record $80,000 of revenue. That amount would be later adjusted for changes in the probability estimate as the project progresses, until the revenue amount ultimately is adjusted to either $100,000 or $0.

If the variable portion of the price cannot be reasonably estimated, then only the fixed component will be recorded, until such time as the variable portion can be estimated.

The entity also needs to consider any collectibility issues for customers in the initial recording of revenue. This could be a big change from current practice for entities that do business with higher-risk customers. Subsequent changes in collectibility expectations, however, run through bad debt expense, not revenue.

The time value of money works both ways, in reflecting not only customer payments in the future but also prepayments. These calculations for certain types of entities may get somewhat complex.

• Transaction price would be allocated among the performance obligations based upon relative stand-alone selling prices.

The stand-alone selling price can be estimated. For example, say the customer receives an option to buy Product B at a discount, with the purchase of Product A. The stand-alone selling price for the option would be estimated from (1) the discount offered relative to discounts offered on Product B outside of this option, and (2) the probability that the option will be exercised.

If the sum of the stand-alone selling prices for Products A and B exceed the transaction price, then the transaction price will be proportionately allocated.

• Losses would be recognized on a performance-obligation basis rather than on a contract basis.

Consistent with the separate accounting required for performance obligations, if the expected direct costs of satisfying the obligation exceed the transaction price allocated to the obligation, a loss is recognized on a performance-obligation basis, rather than on a contract basis. (This is called an onerous performance obligation.)

An entity could therefore end up in recognizing a loss in the early stages of a contract, when the overall contract is profitable.

• Contract modifications would result in either a catch-up adjustment in the period of change or would be recorded prospectively.

Accounting for contract modifications is tied to price interdependence between the original and modified contract.

• Revenue is recognized when performance obligation is satisfied.

A performance obligation is satisfied when the customer obtains control of the goods and services. The proposed standard includes the following indicators of control:

• unconditional obligation to pay,
• legal title,
• physical possession, and
• customer's specifications of design or function.

The proposed standard also notes that none of these indicators by itself would determine that the customer had control.

However, even with this guidance, many feel that the standard has not clearly related the concept of "transfer of control" to long-term, construction-type contracts.

Other Common Questions and Answers

Other Common Questions and AnswersIs Percentage-of-Completion Accounting Dead? FASB has been very clear that not all construction contracts would be accounted for using completed-contract accounting under the proposed standard. FASB has also been very clear that it intends for construction contracts to be covered by this proposed standard, so we are not expecting any future carve-outs here. We are expecting, however, that entities with longer-term contracts will be spending some significant time analyzing and evaluating these contracts, and also may end up with some accounting changes.

Why, Why, Why Is the FASB Doing This to Us All? The FASB doesn't think it makes sense that two economically identical transactions in different industries are accounted for differently. In addition, they are working to achieve greater consistency with international standards.

Are There Any Exceptions? Right now, leases, insurance contracts, and certain financial instruments are carved out, as are guarantees other than product warranties and non-monetary-product exchanges to facilitate a sale to another party.

Are Only Customer Contracts That Are Signed After the Effective Date Subject to the Standards? Unfortunately, no. The proposed standard will impact all contracts in place on the first day of the earliest period presented in your financial statements, in the year in which the standard is effective. Therefore, gathering information, analyzing the agreements, etc. would need to be done for any customer contracts in place at that date.How Likely Is It That FASB Will Approve the Proposed Standard? The exposure draft was passed unanimously by both FASB and the international accounting standard setters, so they felt pretty good when they issued it. They have received many comment letters, however, and have developed a plan for re-deliberating the issues raised. This month, FASB is considering the "two fundamental issues" of (1) separating a contract into performance obligations and (2) transfer of control. We do expect them to issue a new standard, however, with some changes perhaps.

The standard setters are aiming for the late second quarter for final issuance, but don't be surprised if it doesn't make it out until the early third quarter.

Suggested Next Steps

Given that we don't expect an effective date earlier than 2013, we might do a bit of a "wait and see what happens this summer" with this standard. The FASB might do some tweaking of some of the more intricate aspects of the proposed standard. We do, however, recommend the following in the short term just to get an idea of what to expect:

Identify all the types of contracts that your entity has with its customers - written, oral, or other enforceable obligations.

Identify all goods and services that are promised to customers.

Determine if the individual goods and services are performance obligations; i.e., are they distinct? If they are, then you will have multiple revenue streams to process.

Depending upon your expectations of the impact of this proposed standard, you may want to evaluate the sufficiency of your systems and controls, as the accounting process for revenue would involve initial evaluation and estimates of customer credit risk and any variable compensation and periodic reassessments of certain estimates, as described above, that you did not previously need to perform. Your current software may not allow for this, and you may end up needing new software. Your internal budgeting process may also need some tweaking.  

A Final Important Note

This issue includes a brief overview of the proposed standard. If you have any questions on this or another upcoming standard, please contact us. We will address your question in a subsequent issue, space permitting.

You can find the complete proposed standard at fasb.org.

Also, please do contact your Blackman Kallick accounting team for assistance in addressing your specific facts and circumstances. Your Blackman Kallick accounting team is happy to help you sort through this, or just help you get started on the "road ahead." 

Blackman Kallick’s The Road Ahead-Accounting Updates publication has been prepared for general information on the specified topic. Application to your particular facts and circumstances should be carefully considered in light of the actual accounting standard or exposure draft and in consultation with your Blackman Kallick accounting team.

 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.