Over the past several months Clayton & McKervey has provided information about the new revenue recognition standard released by the Financial Accounting Standards Board (FASB); (Revenue from Contracts with Customers: Topic 606). The standard replaces the current revenue guidance found in multiple places in the FASB codification, and provides a single comprehensive standard that will apply to nearly all industries and will significantly change how revenue is recognized.
The standard provides a five step process for recognizing revenue, as follows:
- Identify the contract with the customer
- Identify the performance obligations in the contract
- Determine the transaction price for the contract
- Allocate the transaction price to each specific performance obligation
- Recognize the revenue when the entity satisfies each performance obligation
Step 3, determining the transaction price for the contract, describes the promise a customer makes to pay for the performance obligations identified in the contract. ASU 606 defines transaction price as the amount of consideration the entity expects to be entitled to, in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (eg. sales tax).
In some revenue transactions the transaction price is clear. For example, a customer walks into a store and buys a new coat for its normal full price of $200. The customer pays the money to the store and the store gives the customer the coat. The transaction is complete and the store records $200 of revenue.
Under the new revenue recognition standard, this straightforward transaction could become complicated if, for instance, the customer can return the coat for a full refund. Complexities like variable consideration, rights of return and other terms inherent in some contracts can make determining the transaction price a little tricky.
Variable consideration is an amount dependent on the occurrence or non-occurrence of a future event. Variable consideration includes discounts, rebates, refunds, price concessions, incentives, performance bonuses, penalties, rights of return and other price modifications. The variability can be explicitly stated in the contract or can be implied through customer business or industry practices or other means. ASC 606 requires an entity 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 US GAAP which would not have a company record variable consideration until the contingency was resolved.
In the new standard, variable consideration can be estimated two ways:
- The expected value method which is the sum of the probability weighted amounts in a range of possible outcomes.
- “The most likely amount method” which is the one most likely outcome of the contract. This method is best suited to when there are only two possible outcomes, such as a company finishes ahead of schedule and receives a performance bonus or not.
These two methods are not intended to be policy choices. A company is supposed to pick the method which is the best estimate of the variable consideration depending on the facts and circumstances. In general, the concept of variable consideration applies to contracts where the revenue will be recognized over time rather than at a point in time.
Constraining Estimates of Variable Consideration
As previously mentioned, the transaction price should include an estimate of variable consideration only if it is unlikely that there will be a significant reversal of the revenue recognized when the uncertainty related to the variable consideration is resolved.
In assessing whether it is probable that there will be a significant reversal in revenue recognized, both the likelihood and the magnitude of the revenue reversal are considered. Factors which could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following:
- The amount of consideration is highly impacted by factors outside the entity’s influence. Things such as volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
The entity’s experience with similar types of contracts is limited making it difficult to predict the likelihood of reversal.
- The entity typically offers a broad range of price concessions or changes payment terms and conditions of similar contracts in similar circumstances.
- The contract has a large number and broad range of possible consideration amounts.
Under the new standard revenue should be offset by a refund liability if the company expects that refunds will occur. The amount of the refund liability should be estimated, and the estimate adjusted each reporting period. When a right of return exists, in addition to the right to a refund, an asset is recognized with an offset to cost of goods sold for the value of the expected returned goods. This means the entry to record revenue would look something like this:
Refund Liability: Right of Return:
Accounts receivable: 100 Right of return asset: 5
Revenue: 80 Cost of goods sold: 5
Refund liability: 20
The estimates of the refund liability and right of return asset should be updated at the end of each period resulting in an increase or decrease in the revenue recognized. A right of return asset is measured at the original inventory carrying amount, less the expected cost to recover the asset, less any anticipated decrease in the value of the asset.
Significant Financing Components
ASC 606 requires an entity to adjust the transaction price for the time value of money even if the contract does not explicitly call for a financing component. For contracts where the period of time between delivery of the product or services to the customer and the customer payment is less than a year, there is a practical expedient that can be used to eliminate consideration of the time value of money. For all other long term contracts, an entity must consider if there is a financing component. (If customer payments are deferred, the entity recognizes interest income; if payments are accelerated, the entity recognizes interest expense.) In order to assess in a contract contains a financing component and if it is significant to the contract the analysis should consider if:
- There is a difference between the amount of promised consideration and the true cash selling price of the promised goods or services, and
- The combined effect of both of: (a) the expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services; and (b) the prevailing interest rates in the relevant market.
- The standard lists certain situations that would not indicate a financing component. These are:
- The customer paid for the goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer.
- A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event not substantially within the control of the customer or the entity (eg. if the consideration is a sales-based royalty).
- The difference between the promised consideration and the cash selling price of the good or service arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract.
The interest income or interest expense should be presented separately from revenue from contracts with customers in the income statement. Interest income or interest expense is recognized only to the extent that a contract asset (or receivable) or a contract liability is recognized in accounting for a contract with a customer.
Non Cash Consideration
Some contracts may include arrangements in which a customer promised consideration in a form other than cash. The estimated fair value of the non-cash consideration at the beginning of the contract should be included in the transaction price. Any variation in the fair value of non-cash consideration after the initial measurement at contract inception does not affect the transaction price.
Consideration Payable to a Customer
Consideration payable to a customer includes cash amounts paid, or expected to be paid, to the customer as well as things like credits, coupons or vouchers that can be applied against what is owed to the seller company. Consideration payable to a customer reduces the transaction price and therefore revenue the company recognizes in a transaction unless the consideration is in exchange for a distinct good or service and does not exceed the fair value of that good or service.
Clearly, determining the transaction can be more complicated than it sounds. The considerations above historically have not been required in determining the amount of revenue recognized. Depending on the particular facts and circumstances, variable consideration may result in the acceleration of revenue recognition. The analysis of all of the factors needed to determine the transaction price will require significant judgments by management. It will be important to make sure that the processes and controls are strong in order to support consistent and reliable revenue reporting.