Dissecting the New Revenue Recognition Guidance: Step 1 of the Five-Step Framework

This article provides a high-level summary of Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, as amended, and then focuses on Step 1 of the five-step framework defined in the ASU. Future articles will address the remaining four steps as well as provide detailed guidance on issues that may be encountered while implementing the new revenue recognition standard. 

Executive Summary

In May 2014, the Financial Accounting Standards Board (FASB) issued ASU No. 2014-09, Revenue from Contracts with Customers, as subsequently amended, which resulted in the most significant revision to revenue recognition standards that U.S. GAAP has ever seen.

The new guidance will impact companies in every industry that recognizes revenues from contracts with customers. Public companies were required to comply with the new standard for the year ending Dec. 31, 2018, while most nonpublic companies are provided an additional year, requiring compliance for the year ending Dec. 31, 2019.

The new guidance provides that revenue should be recognized when a performance obligation is met in an amount that reflects the consideration to which the entity expects to be entitled to for the exchange of the goods or services.

Under the new guidance, an entity will go through a five-step process to determine when revenue is recognized and to what value it is recognized:

1. Identify the contract(s) with a customer.
2. Identify each performance obligation within the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the identified performance obligations.
5. Recognize revenue when (or as) the performance obligations are satisfied.

There are minimum requirements in order to recognize revenue under the standard. If these minimum requirements are met, revenue is recognized when a customer obtains “control” of the promised good or service or continuously through the life of the contract.

The first minimum requirement specifies that an entity must have an arrangement with a customer that meets the definition of a contract under the standard.

The second minimum requirement requires that the contract must satisfy all the criteria (contract revenue recognition criteria) listed below:

• The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations,
• The entity can identify each party’s rights regarding the goods or services to be transferred,
• The entity can identify the payment terms for the goods or services to be transferred,
• The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract), and
• It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.

An entity that does not satisfy the minimum requirements noted above will not be able to recognize revenue until the entity has been paid by the customer, and it has no further obligations to the customer.

Step 1: Identify the Contract with a Customer

How does the standard define a contract? A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral, or implied by an entity’s customary business practices.

An entity should apply the requirements in the standard to each contract that meets the following criteria:

1. Approval and commitment of the parties,
2. Identification of the rights of the parties,
3. Identification of the payment terms,
4. The contract has commercial substance, and
5. It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.

The guidance shall be applied to the duration of the contract in which the parties to the contract have present enforceable rights and obligations. If a contract with a customer meets the above criteria, it should not be reassessed unless there is an indication of a significant change in facts or circumstances. Conversely, if a contract does not meet the criteria above the entity should continue to assess the contract to determine if the criteria are subsequently met.

Specific Concerns Related to Contract Identification

The standard addressed the following items related to contract identification which may ease the process of identifying and assessing whether a contract exists.

Combination of Contracts

An entity shall combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account for the contracts as a single contract if one or more of the following criteria are met:

1. The contracts are negotiated as a package with a single commercial objective,
2. The amount of consideration to be paid in one contract depends on the price or performance of the other contract, or
3. The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation.

Contract Modifications

According to the new revenue recognition standard, contract modifications exist when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract. A contract modification could be approved in writing, by oral agreement, or implied by customary business practices. If the parties to the contract have not approved a contract modification, an entity should continue to apply the guidance to the existing contract until the contract modification is approved. Contract modifications may be accounted for as a separate contract if certain conditions are present, as defined in the standard.

Costs to Obtain or Fulfill a Contract

Incremental costs of obtaining a contract: An entity should recognize as an asset the incremental costs of obtaining a contract (costs the entity would not have incurred if the contract was not obtained) that the entity expects to recover. As a practical expedient, an entity may expense these costs when incurred if the amortization period is one year or less.

Costs to fulfill a contract: To account for the costs of fulfilling a contract with a customer, an entity should apply the requirements of other standards, if applicable. Otherwise, an entity should recognize an asset from the costs to fulfill a contract if the costs (1) relate directly to a contract, (2) generate or enhance resources of the entity that will be used in satisfying performance obligations in the future, and (3) are expected to be recovered.

Does Your Contract Meet the Criteria?

Entities need to consider whether their arrangements meet the minimum requirements for recognition of revenue under the standard as the consequence for not meeting the criteria is to put the revenue-generating activity effectively on the cash basis of accounting. Failure to satisfy the minimum requirements to recognize revenue can have a significant impact on the financial statements.

In order to meet the minimum requirements to recognize revenue, it may be necessary to change contracting practices with customers. This will be especially important in industries where current industry practices may not comply with the minimum requirements to recognize revenue.

We suggest all entities complete an examination of current contract provisions that detail payment terms, the rights and obligations of the parties, and collectability provisions (such as progress payments, security interests, and guarantees). The results of this examination can help determine whether or not your current contracting practices are adequate to meet the requirements of a “contract.”

Additionally, contract enforceability is a legal determination that will require an assessment from attorneys; therefore, it may be necessary to revise contract language to address enforceability in the jurisdiction in which the contract is governed. This may lead to more arrangements being covered by written documents in order to address enforceability concerns.

Entities also should be reviewing any changes in contractual arrangements with vendors. Changes which are made to address the minimum requirements to recognize revenue are likely to materially alter the position of the parties in the event of a dispute and should be thoroughly vetted in advance.