Revenue Recognition 5 Steps Model – Steps 1 and 2

The new revenue recognition model is a 5 steps model that guides companies in determining the amount and the timing of when revenues should be recorded. It shifts from the existing risk and reward model to one that emphasizes control. Here are the 5 steps:

  1. Identify the contract with the customer
  2. Identify the performance obligation, i.e. the goods and services to be provided to the customer
  3. Determine the transaction price
  4. Allocate the contract value to the goods and services to be provided
  5. Recognize revenues as goods and services are delivered to the customer

In this month’s newsletter, we’ll take a look at the first two steps and then steps 3 to 5 next month.

  1. Identify the contract with the customer

A contract is defined as an agreement between two or more parties that create legally enforceable rights and obligations. It can be written, oral or implied based on customary business practices. If a contract provides for each party to terminate the agreement without penalty, then there is no accounting consequences related to the contract since there is not a legally enforceable right and obligation to the parties. However, just because there are legally enforceable rights and obligations, it doesn’t mean that you are in the clear. There are still some criteria that need to be evaluated to determine whether a contract exists.

  1. Does the contract have commercial substance?
  2. Have approvals been obtained and commitment to perform exist for both parties?
  3. Are rights of both parties are identifiable?
  4. Are payment terms identifiable? And
  5. Is collection probable?

Once these criteria are met, reassessment is not necessary unless signification changes in circumstances occur.

What if an entity goes through step 1 and determines that a contract does not exist? In this situation, any considerations received should be recognized as a liability and the entity should reassess the criteria each reporting period. If the criteria continue not to be met, the entity can only recognize revenues when the considerations received are nonrefundable and

  1. There are no remaining performance obligations and substantially all amounts have been received.
  2. The contract has been terminated. Or
  3. The entity has transferred the control of goods and services to which the nonrefundable considerations relate and the entity has no future obligation to transfer additional goods and services.

The last criterion differs from current guidance in that it allows for recognition of revenue in the amount related to the goods and services transferred even though the entity continues to perform under the contract.

Contract modifications – The guidance on contract modifications is new in comparison with existing guidance, except in contract accounting. The accounting for contract modifications allows for prospective treatment, a cumulative catch up adjustment or account for as a separate contract, depending on facts and circumstances. Some of the issues to consider include whether the changes are approved; the pricings of the modifications; any distinct new products or services added, etc.

  1. Identify the performance obligation, i.e. the goods and services to be provided to the customer

The overall objective of step 2 is to identify the units of account to which the entity will then apply steps 3 to 5 to. The entity will identify all of the promised goods and services, considering both explicit and implicit promises, based on customary business practices.

Next, the entity needs to consider whether the identified goods and services are distinct. If so, they are accounted for separately as a performance obligation, i.e. unit of account. Otherwise, the entity should combine other goods and services until there is a group that is distinct. The guidance does provide an exception that when goods or services are part of a series of distinct goods or services that are substantially the same, the series of goods or services is the performance obligation. A good example of this is television/cable services – the customers typically are locked into a contract and each hour of the service provided is distinct. However, since each hour of the service is substantially the same and is delivered in the same manner, they are counted as one performance obligation.

Since distinctiveness is a key factor, how does an entity determine whether a good or service is distinct? A good or service is capable of being distinct when a customer can benefit from it on its own or together from other readily available resources. For example, an entity sells equipment to its customers. The customers can sell the equipment on a standalone basis. The customers can use the equipment together with other goods or services that have already been transferred by the entity, i.e. installation service for equipment purchased by the customers; or installation services from other providers in the marketplace.

The entity should also consider whether warranty is a distinct performance obligation. If the customer has the option to purchase the warranty separately, then the warranty is a performance obligation. Otherwise, the entity should allocate part of the purchase price to the warranty and recognize revenues over time.

In addition, if the customer has the option to purchase additional goods and services, the option is a performance obligation for accounting purposes if it provides material right to the customers that the customers would not otherwise have without entering into the contract.

When is it effective?

Effective date for public entities is the first interim period within annual reporting periods beginning after December 15, 2017, i.e. 2018 for public companies with December 31 year end; nonpublic entities have an additional year. It also allows early adoption as early as 2017 calendar year.