It’s here! The Financial Accounting Standards Board’s (FASB) 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 data in accordance with the new standard, some are still in the process and playing catch-up. For those that still need to implement the standard, consider these key areas that are likely to impact professional service companies:
- Identifying performance obligations in a contract
- Accounting for variable consideration
- Deciding whether revenue should be recognized over time or at a point in time
- Determining appropriate methods to recognize revenue over time
- Accounting for contract modifications
Identifying performance obligations in a contract
This 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.
For professional services companies, it is important to note that just because a good or service is capable of being distinct, doesn’t mean that it is 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
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 stand-alone basis, if a contract is written so that the services are fluid throughout the design and construction period, the two services may be considered one performance obligation of engineering services provided. Each contract must be evaluated separately to make these determinations.
Accounting for Variable Consideration
Variable consideration likely to affect professional service companies includes discounts, rebates, refunds, price concessions, incentives, performance bonuses, penalties 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 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” 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.
Companies need to apply the method which 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. Performance obligations are completed and revenue is recognized either at a point in time or over a period of time, depending on certain facts.
At a point in time – a company has to go through the criteria to determine if a performance obligation is satisfied over time. If it does not meet those criteria, then the performance obligation is satisfied and revenue recognized at the point in time 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 one of the following are met:
- The customer receives and consumes the benefits of the goods or services as they are provided by the entity (routine, recurring services like a cleaning service are an example of a series of services that are substantially the same and have the same pattern of transfer)
- The goods or services create or enhance an asset that the customer controls as that asset is created or enhanced (this would be common for contractors who may 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 (some examples are 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 and revenue is recognized over time, it is similar to what is known in the current revenue recognition literature as a percentage of completion. The primary difference is that the 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, milestone 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, a termination of an existing contract and creation of a new contract, or part of the existing contract.
If the scope of the goods or services outlined in the contract modification are distinct and at a stand-alone selling price, then the modification is treated as a separate contract. As outlined above, 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 creation of a new contract. 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. 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 and a cumulative catch-up adjustment to increase or decrease revenue, if necessary, would be made to account for the additional contract component.
Important note
While different professional service companies will be impacted by the standard in different ways, it is imperative that companies address these considerations and others within ASC 606 to 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: FRF for SMEs
Another consideration for non-public professional service companies is to determine if US GAAP is still the best reporting framework for them. With the complexity of the revenue recognition standard, and then significant changes to the leasing standard in the following year, some are considering other financial reporting frameworks more relevant for their business.
During 2013, the AICPA introduced the Financial Reporting Framework for Small and Midsized Entities (FRF for SMEs). FRF for SMEs is a special purpose framework based on the principles of GAAP, but tailored to meet 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, companies should take a closer look at the FRF for SMEs framework as a reporting alternative.
While FRF for SMEs is not GAAP, there are minimal differences between the two frameworks for everyday accounting issues. Although these are different reporting options, the level of assurance of an audit or review stays the same no matter which reporting option is used. For clarity, 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 to maintaining traditional GAAP accounting related to revenue transactions and operating and capital leases, FRF for SMEs is very similar to traditional GAAP for most transactions that affect privately held companies.
Clayton & McKervey has seen many clients successfully adopt the FRF for SME since 2013. The firm has been able to educate bankers and other stakeholders about the framework so that it is accepted for financial reporting requirements. It can be an excellent solution for those companies that do not need US GAAP financial statements.
If your company needs to continue to report on US GAAP and you are behind in implementing the revenue recognition standard we can consult with management to get you back on track.
