Revenue Recognition: What Is the Impact of the New Standard on the

Intermediate Accounting Course

Jefferson P. Jones Auburn UniversityDonald P. Pagach North Carolina State

University

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Intermediate Accounting: Reporting & Analysis 2e

Publishes 2/15/15

FASB/IASB Revenue Project

• Initial Identification of the topic - 2002

• Initial exposure draft – June 2010

• Revised exposure draft – November 2011

• Final standard – May 2014– GAAP - Annual reporting periods beginning after Dec. 15, 2016

– IFRS - Annual reporting periods beginning on or after Jan. 1, 2017

– Retrospective application – practical expedient allowed

– Early application is prohibited under GAAP, allowed under IFRS

Core Revenue Recognition Principle

• Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

• Contract-based revenue recognition principle4

Company Customer

CONTRACT

Enforceable rights

and obligations

General Framework

• Asset/Liability Approach: Revenue is based on changes in the assets and liabilities arising from an entity’s contract with a customer.

• Contract gives the seller the rights to receive consideration and imposes obligations to transfer goods or services to the customer (performance obligation).

• An entity recognizes revenue from increases in its net position in a contract as it satisfies a performance obligation.

Scope

• Applicable to all contracts with customers, except for:– Lease contracts

– Insurance contracts

– Contractual rights or obligations within the scope of other topics (e.g., financial instruments, debt, etc.)

– Guarantees (other than product or service warranties)

– Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers

Five Step Model of Revenue Recognition

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Step 1• Identify the contract with a customer

Step 2• Identify the performance obligations in the contract

Step 3• Determine the transaction price

Step 4

• Allocate the transaction price to the performance obligations in the contract

Step 5

• Recognize revenue when, or as, the company satisfies a performance obligation

Step 1: Identifying the Contract with the Customer

• What is a contract?– An agreement between two or more parties that

creates enforceable rights and obligations

– Meets the following requirements:• The contract must be approved by each party

• The company must be able to identify each party’s enforceable rights regarding the goods or services to be transferred

• The company has to be able to identify the payment terms for the goods or services to be transferred

• The contract must have commercial substance

• It is probable that the company will collect the consideration to which it is entitled

Step 1: Key Issues– Termination Rights: wholly unperformed contracts

that can be unilaterally canceled without penalty.

– Combining Contracts: Combine two or more contracts entered into at or near the same time with the same customer (or related parties) if one or more of the following criteria are met:• The contracts are negotiated as a package with a single

commercial objective

• The amount of consideration to be paid in one contract depends on the price or performance of the other contract

• The goods or services promised in the contracts are a single performance obligation

Step 1: Key Issues

– Contract Modification: • Treated as a new, separate contract, if:

– Distinct goods or services or added AND

– Price increases by an amount that reflects the standalone selling price of the additional goods or services

• If not a separate contract, then the modification is treated as an adjustment to the original contract.– Prospective Method

– Cumulative Catch-Up Method

– Collectability• Reduce the contract price for ay amounts the seller

does not expect to collect

Step 2: Identify Performance Obligations

– What is a performance obligation?

• A promise (implicit or explicit) in a contract to transfer a good or service.

– When do separate performance obligations exist?

• Key: Distinct goods or services

• A good or service is distinct (and accounted for separately) if it is:– Capable of being distinct: Customer can benefit from the

good or service on its own or with other readily available resources

– Distinct within the context of the contract: Seller’s promise is separately identifiable from other promises in the contract (e.g., no significant integration, modification, customization)

Example – Identifying Performance Obligations

• Nonrefundable Upfront Fees: A health club offers one-year memberships for a nonrefundable fee of $100 paid at the inception of the contract and $50 a month.

• Customization of software: A company provides a two-year software license to a customer as well as two years of bundled customer support. Neither the software nor the customer support are sold on a stand-alone basis.

Example – Identifying Performance Obligations

• Construction: A company enters into a contract to build a building. The company is responsible for the overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing.

Step 3: Determine the Transaction Price

• The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer

• Must consider:– Variable consideration

• Expected value or most likely amount approach• Constraint

– Time value of money – Noncash consideration– Consideration paid to a customer

Example – Determining the Transaction Price

• Sale with right of return: A company sells 100 products for $100 each. The company allows the customer to return any unused product within 30 days and receive a full refund. The cost of each product is $60. The company estimates that 3 products will be returned. – Revenue = $9,700 (97 x $100)

– Return liability = $300 (3 x $100)

– COGS = $5,820 (97 x $60)

– Return asset = $180 (3 x $60)

Step 4: Allocate the Transaction Price

• Determine the standalone selling price of each performance obligation– Best evidence → Observable price– Use best estimate if observable price is not available

• Adjusted market assessment approach• Cost plus a margin approach• Residual approach

• Allocate transaction price to separate performance obligations based on the relative standalone selling price

• Any subsequent changes in transaction price are allocated to separate performance obligations on the same basis as at contract inception– Amounts allocated to satisfied performance obligations are

recognized as an adjustment to revenue in the period of the change

Step 5: Recognize Revenue When Performance Obligations are Satisfied• Performance obligations are satisfied when

control of goods or services (assets) are transferred to a customer

• Control of an asset refers to the ability to direct the use of and obtain substantially all of the remaining benefits from the asset.

• Example: – Consignment arrangements– Bill-and-hold arrangements

• Key Question: Are performance obligations satisfied over time or at a point in time?

Performance Obligations Satisfied Over Time

• Three criteria (must meet only one):

– The customer simultaneously receives and consumes the benefits of the seller’s performance as the seller performs

– The seller’s performance creates or enhances an asset that the customer controls OR

– The seller’s performance does not create an asset with alternative use to the seller and the seller has a right to payment for the work completed to date.

• Appropriate measure of progress must be selected - output or input methods allowed

Example – Performance Obligation Satisfied Over Time

• A company enters into a contract to construct a cruise ship. The ship is designed and manufactured to the customer’s specifications. Physical possession of and title to the ship remain with the seller during construction. The customer agrees to make periodic payments throughout the construction of the ship that are intended to at least compensate the company for performance to date. If the contract is canceled by the customer, there would be significant rework costs to make it useful to another customer.

Performance Obligations Satisfied At A Point in Time

• Indicators of a transfer of control:

– The seller has the right to payment

– The customer has legal title to the asset

– The seller has transferred physical possession of the asset

– The customer has the significant risks and rewards of ownership of the asset

– The customer has accepted the asset.

Presentation and Disclosures

• Objective: To help users understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers

• Presentation:– Receivables, contract assets, contract liabilities– Revenue from contracts vs other revenues

• Disclosure:– Disaggregation of revenue– Reconciliation of contract asset and liability balances– Information about performance obligations– Significant judgments

• Overall, Disclosures will be more extensive

Conclusion

• Principles-based standard which provides student with a more general framework

• Effect on the classroom

– The results are often consistent with current practice

– Presentation of the 5-step model in lieu of “earned” and “realized or realizable” discussion

– Increased complexity of the discussion?

Questions?

• Contact any of the authors if you have additional questions

• Jim Wahlen 1-812-855-2658

– jwahlen@Indiana.edu

• Jeff Jones 1-334-844-6223

– jjones@business.auburn.edu

• Don Pagach 1-919-515-4447

– Don@NCSU.edu