After years of debate, revision, and refinement, ASC 606 is finally coming into effect. The Financial Accounting Standards Board (FASB) released its initial major Accounting Standards Update (ASU) about revenue recognition in May of 2014—ASU 2014-09—and has since received thousands of comments and issued six subsequent ASUs on the topic. This major overhaul of the revenue recognition framework—formerly ASC 605—takes effect for fiscal years beginning after December 15, 2017 for all public entities, certain not-for-profits, and certain employee benefit plans.
Within the retail and consumer products industry, the common practice of using sales incentives and loyalty programs, warranties, and licensing and franchise arrangements should be analyzed for potential impact on the timing and extent of revenue to be recognized. The AICPA and the major accounting firms have assembled industry task forces to research the industry-specific accounting issues with ASC 606, and we will draw from the guides they have published to give you an idea of some of the issues you should expect. For more information on any of these issues, see:
- Ernst & Young: Technical line—The new revenue recognition standard – retail and consumer products
- PWC: In depth—Retail and consumer industry supplement
We will also provide references to other RevenueHub articles for more detailed explanations of ASC 606 topics. See our Revenue Hub article, The Five-Step Method, for more general information.
The following are the issues that companies in the software industry commonly face:
- Rights of return (variable consideration)
According to the PwC industry guidance, although rights of return are common in the retail and consumer industry (e.g., stock rotation and returns upon termination of contract), the new revenue recognition standard will likely not have a significant impact on this element of most retail entities’ accounting. Under current U.S. GAAP, if an entity is unable to reasonably estimate the volume of potential returns, revenue is deferred until the right to return lapses. Under the new standard, entities must estimate the impact of potential returns using either a probability-weighted approach or the most-likely outcome. Because revenue can now be recognized when it is probable that a significant reversal will not occur, ASC 606 may accelerate revenue recognition relative to ASC 605.The amount an entity expects to be returned will be initially reflected through the creation of a returns liability type account. The entity will also record (1) an asset for the goods expected to be received from the customer, and (2) a corresponding adjustment to the cost of sales account as the refund liability is settled. Entities should use the variable consideration guidance to determine the extent of revenue to be recognized.
The transition to ASC 606 was a significant concern for retail companies because, due to the volume of contracts, allocating variable consideration at the individual-contract level would not be practicable. However, in practice, the application of ASC 606 should not materially differ from that of ASC 605 with regard to refund liabilities. Although this variable consideration can be allocated on an individual-contract level, it may also be allocated using the portfolio method (i.e., allocating based on groups of similar contracts). Historical data is needed to reasonably and reliably estimate the amount of refund liability to be recognized under the portfolio approach. For more information on the portfolio approach, please see our article, Contract v. Portfolio Method.
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- Customer options for goods or services (including loyalty programs)
If the option to receive additional goods or services constitutes a material right, then the entity should record the option as a separate performance obligation within the contract. In accordance with the PwC industry guidance regarding loyalty programs, the customer is paying for future goods and services that will be received in exchange for earned reward credits. Consistent with the five-step recognition model of the new revenue recognition standard, the entity must develop a standalone selling price for the loyalty program, then allocate a portion of the overall contract transaction price to the loyalty program based on the relative standalone selling price. The entity recognizes revenue when the option is exercised or expires.
In contrast, current US GAAP typically uses two models to account for loyalty programs: (1) an incremental cost accrual model, and (2) a multiple-element revenue model. Under the incremental cost method, revenue is recognized at the point of initial sale and the expected costs of satisfying the loyalty program are recorded as an accrual. PwC notes that the new standard will thus result in comparatively delayed revenue recognition.
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- Reseller and distributor arrangements
At present, compliance with SEC Staff Accounting Bulletin (SAB) Topic 13 causes some retail entities to defer the recognition of revenue until the product transfers to the end customer, as opposed to when the product is delivered to the reseller. Under the new revenue recognition standard, control is the key element in determining when to recognize revenue in reseller and distributor arrangements.
To determine when control is transferred, the entity must first evaluate whether the contract is a consignment arrangement. In a consignment arrangement, the reseller functions as an intermediary, so control is not effectively transferred until the product is sold to the end customer. If the contract is not deemed to be a consignment arrangement, the reseller is considered the end customer, and control is transferred upon delivery. Further, the extent of revenue to be recognized is contingent upon the amount the entity reasonably estimates entitlement to, considering the constraint on variable consideration. Therefore, an entity may be able to recognize revenue earlier than it does today if it is probable that at least part of the amount to be recognized will not be subject to a significant reversal.
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- Licenses and franchise arrangements
Licenses and franchise arrangements are typical in the retail and consumer industry because most products have a licensed image or name—for instance, a license or franchise agreement exists when a retailer has contracted to use another entity’s brand or logo either on or as a part of its products. License arrangements are transfers of rights either at a point in time (obligation to provide a future right) or over a period time (access to an entity’s intellectual property). PwC industry guidance indicates that the entity must determine whether the license provides a right to access or a right to use an entity’s intellectual property (IP).
With a right to access, the IP is subject to change by the licensor. That is, the licensor’s activities can change the form or functionality of the IP, or the licensee’s ability to derive benefit from the IP is impacted by those same activities. So, at the initial transfer, the licensee neither obtains substantially all the benefits that will ultimately be available nor directs the use of said benefits. Thus, with licenses that provide a right to access IP, revenue is recognized over time. In contrast, with a right to use, the IP received by the customer at the initial transfer is not subject to change by the licensor throughout the licensing agreement. With a right to use, revenue is recognized upfront upon delivery.
In ASC 606-10-55-59, the Codification distinguishes between the two types of IP: functional intellectual property (e.g., completed media content, drug formulas or compounds, software, etc.) and symbolic intellectual property (e.g., franchise rights, brands, logos, etc.). In general, retail-company contracts will concern symbolic IP. Symbolic IP does not have significant standalone value, so it therefore provides a right to access rather than a right to use. For a more in-depth explanation on the nuances of both functional and symbolic IP, please see our article, Licenses for Intellectual Property.
The entity must also analyze the arrangement for the possibility of a variable consideration component (especially regarding royalty revenues) to determine the overall transaction price, as well as to distinguish between the distinct performance obligations within the contract. For more information on variable consideration in this context, please see our article, Sales- and Usage-Based Royalties.
- Amounts collected on behalf of third parties
In many retail and consumer transactions, the entity acts as an agent to a third-party, like the U.S. Federal and State Governments, by collecting and subsequently remitting amounts from the customers, such as sales taxes. However, some arrangements involve more than two parties (in addition to a governmental entity), so the entity must assess whether its role is that of the principal or that of an agent in the context of each contract.
Under current U.S. GAAP, revenue earned in an agency relationship is recognized net, and shipping and handling costs are also treated as revenues earned and therefore cannot be used to offset reported revenues. An entity can elect whether taxes that are assessed by a governmental authority and fall within the scope of ASC 605-45 are reported at either gross or net.
With the new revenue recognition model, revenue is recognized on a gross basis if the entity is acting as the principal, and on a net basis if the entity is acting as an agent. The key distinction between the role of the principal and that of the agent under this standard is control. If the entity obtains control of the goods or services prior to transferring them to the customer, then it is the principal. If the entity’s performance objective is the arranging, but not controlling, of a third party to provide the goods or services, then it is an agent. PwC industry guidance offers several indicators that the entity is likely an agent, including:
- The other party has primary responsibility for fulfillment of the contract
- The entity does not have inventory risk
- The entity does not have discretion in establishing prices
- The entity does not have customer credit risk
- The entity’s consideration is in the form of a commission
Also under the new standard, sales and excise taxes—and any other amounts collected on behalf of third parties—are not included in the transaction price. (The former standard’s policy election option has been eliminated.) However, the name of the tax is not always indicative of whether the entity is the principal or agent for the tax. PwC suggests that management carefully evaluate the characteristics of both the tax and the associated laws in determining whether the tax should be included in the transaction price.
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It is likely that many other issues and questions will arise within the retail and consumer industry as entities transition to the new revenue recognition standard. This article serves as a base reference point for your research into some of the focal issues anticipated by industry experts. Similar industry-specific issues discussions and resources are available on the Revenue Hub site for all major industries as identified by the AICPA.