In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition (effective for fiscal years starting after December 15, 2017 for public companies) affects almost every sector of the economy, including not-for profit (or non-profit) organizations. Due to customer accommodations embedded into the contracts, collectability concerns, and services that may be combined in a single contract, application of the five-step revenue-recognition model can be particularly complicated.
In this article, we provide a brief explanation of the key issues that educational not-for-profits face when applying ASC 606, drawing on the following guide published by the AICPA’s Financial Reporting Executive Committee (FinREC). The guide focuses on educational not-for-profit entities, but many of the principles in this article also apply to other types of not-for-profit institutions. We will also provide references to other RevenueHub articles for more detailed explanations of ASC 606 topics.
- AICPA Guide: Audit & Accounting Guide—Revenue Recognition
1. Contract Existence
The first step in applying ASC 606 is for the non-profit entity to determine whether a contract with a customer is present. Contracts with customers create enforceable rights and obligations between the customer and the entity. Higher-education institutions should consider the processes of student admission and registration to determine whether enforceable rights and obligations have been created. The entity may need to consult a legal advisor to make this determination.
ASC 606-10-25-4 further clarifies that a contract does not exist if both parties have a “unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party.” The standard further explains that a contract is wholly unperformed if 1) the entity has not transferred any promised goods or services to the customer and 2) the entity has not received (nor is entitled to receive) any consideration for the promised goods or services.
Institutions should evaluate whether consideration has been received from the students, possibly in the form of a nonrefundable enrollment or housing deposit. If a) consideration has been received, b) the institution is entitled to consideration, or c) services have been performed for the student, then the contract is not wholly unperformed and a contract with a customer likely exists.
2. Nonrefundable Deposits
Higher education institutions often receive nonrefundable deposits from students for enrollment or housing. Per ASC 606-10-55-46, these institutions must recognize a contract liability upon the receipt of the prepayment. The contract liability essentially acts as a deferred revenue account by tracking payment that has been received before the entity has provided services. FinREC believes that nonrefundable enrollment and housing deposits generally give the paying student the right to receive instruction or housing from the institution and constitutes a contract with a customer.
Some students forfeit the deposit by not enrolling at the institution or not moving into the associated housing. In such situations, ASC 606-10-55-48 allows entities to recognize the expected breakage1 amount as revenue. In the case of the nonrefundable deposits described earlier, only two outcomes are possible: 1) the student exercises the right to receive services from the institution or 2) the student forfeits the deposit in its entirety. Given the binary nature of the outcomes, FinREC believes that the institution would only record breakage revenue once the student’s right to receive services has expired.
For a contract to exist, the arrangement must meet a collectability threshold. For example, an educational not-for-profit institution must determine that collection of the tuition and housing fees is probable before a contract exists. When assessing the likelihood of collecting customer payments, entities should only consider the customer’s ability and intention to pay when consideration is due. FinREC believes that an assessment of the student’s ability to pay should consider expected payments from third parties (e.g., financial aid from state/federal governments) in addition to the student’s personal resources.
The institution may receive less consideration than the amount stated in the contract due to price concessions extended to the customer. An assessment of collectability should be based on the transaction price after adjusting for any price concessions.
If an institution concludes that collectability from a student is not probable, the institution concludes that no contract with the student exists. The institution cannot recognize revenue unless 1) the circumstances change so that collectability becomes probable or 2) the conditions of ASC 606-10-25-7 are met (see last paragraph of this section). The institution should continually reassess the collectability threshold. If an institution receives more information about a student’s ability to pay or additional consideration is provided, then the institution may deem that collectability is probable and a contract exists. As soon as the institution concludes that a contract exists, it can begin applying the remaining revenue recognition framework as explained in ASC 606.
If the institution initially concludes that collectability from a student is probable, the institution does not need to reassess the analysis unless there are indications of a significant change in the student’s ability to pay. If collection is no longer probable, the institution would stop recognizing additional revenue from the contract until either 1) collectability becomes probable again or 2) the conditions of ASC 606-10-25-7 are met (see below).
ASC 606-10-25-7 provides three circumstances in which revenue may be recognized even though the contract requirements listed in ASC 606-10-25-1 are not met. If any of the three criteria (listed below) are satisfied and nonrefundable consideration has been received from a customer, the institution would recognize the nonrefundable prepayment as revenue. Otherwise, the institution must wait for collectability to become probable.
- The entity has no unfulfilled obligations to the customer and all (or substantially all) of the promised consideration has been received.
- The contract has been terminated.
- The entity has transferred to the customer control of all goods or services relating to the received consideration and has no obligation to transfer additional goods or services.
4. Combination of Contracts
Not-for-profit institutions must consider whether contracts with a customer are bundled together into one contract or treated as separate contracts for revenue recognition. ASC 606-10-25-9 lists three criteria which indicate that the contracts should be included in a single contract:
- The contracts are negotiated together with a single commercial objective.
- Consideration amount depends on the price or performance of another contract.
- The promised goods or services are a single performance obligation.
If any one of the above criteria are met, the contracts should be treated as a single contract for revenue recognition purposes. If none of the criteria are met, then the entity should account for each contract separately. When making these determinations in the not-for-profit industry, institutions should consider whether a discount has been provided for a joint housing and enrollment arrangement.
5. Portfolio Approach Practical Expedient
As a practical expedient, ASC 606 allows entities to apply the revenue recognition guidance to a portfolio of contracts with similar characteristics, rather than applying the guidance to each contract individually, if doing so would not cause the financial statements to differ materially. Institutions should consider the benefits and costs of using a portfolio approach. Using a portfolio approach may streamline the entity’s processes for collectability assessment (see #3) and refund estimation. ASC 606 does not provide guidance about how the portfolio approach may differ materially from the contract-by-contract approach. In the basis for conclusions of ASU No. 2014-09, the FASB explained that it did not intend for each entity to quantitatively evaluate each outcome. Rather, entities are left to use judgement in determining whether a portfolio approach is appropriate.
6. Identifying Separate Performance Obligations
Many educational not-for-profit institutions offer both housing and instructional services to students. If both services are included in the same contract, institutions must determine whether tuition and housing are distinct services. If the services are distinct, then each service is treated as a separate performance obligation.
ASC 606-10-05-4b mentions that goods and services are distinct if “the customer can benefit from the service on its own” or together with readily-available resources. The promise to transfer the goods or services must also be “separately identifiable from other promises in the contract.” ASC 606-10-25-21 provides several factors to consider when determining whether the promises within a contract are separately identifiable. The purpose behind the “separately identifiable” requirement is to classify the entity’s promised performance as a transfer of individual services or a combined item.
FinREC believe that in most instances, tuition and housing are distinct services that should be treated as separate performance obligations.
7. Determining the Transaction Price
When determining the transaction price for each contract, not-for-profit institutions should include all consideration that they expect to receive. Some educational institutions offer different rates for tuition and housing based on the age, military service, and/or primary residence (in-state versus out-of-state tuition) of the student. As a result, the price charged to each student and the associated transaction price vary from contract to contract. ASC 606 further explains that the transaction price can include amounts paid by third parties on behalf of the students (e.g., parents, employers, federal/state governments, private institutions).
8. Consideration to the Customer
Educational not-for-profit institutions often provide discounts to tuition and housing charges. Financial aid is commonly provided to students as a form of price reduction. Such price reductions may qualify as consideration payable to the customer. When determining the transaction price for a contract, institutions must reduce the transaction price by the amount of any consideration that must be paid to the customer.
When evaluating the contract for consideration payable to a customer, institutions must determine whether the price reductions are made in exchange for a distinct good or service. For example, some universities reimburse tuition if students work for the university. When price reductions are made directly in exchange for a distinct good or service, then the reductions should be classified as expenses rather than reductions in revenue. These reductions would be reported in the same functional classification in which the cost of other goods or services provided to the entity are reported.
In other situations, the price reductions are not made in exchange for a distinct good or service. For example, universities routinely give scholarships to current students without requiring the student to provide any goods or services to the university. In these circumstances, the price reduction should be treated as a reduction in the transaction price and as a result the amount of revenue recognized. FinREC believes that revenue reductions associated with housing and tuition price reductions would generally be recognized as revenue is received, per ASC 606-10-32-27.
Sometimes, price reductions are provided partially in exchange for a distinct good or service. In these circumstances, the fair value of the price reduction to the customer exceeds the fair value of the good or service provided by the customer. The value of the price reduction related to the good or service provided by the customer would be classified as an expense. The amount of price reduction in excess of the fair value of the good or service provided by the customer should be treated as a reduction of the transaction price.
If the fair value of the customer-provided good or service cannot be reasonably estimated, the price reduction should be treated as a reduction to the transaction price and hence a reduction to the amount of revenue recognized.
9. Right to Withdraw
Educational institutions often give students a period of time during which they may withdraw from classes without incurring additional financial obligations. Student withdrawals may force the institution to provide a full or partial refund for tuition that has been paid in advance.
When institutions receive consideration that they believe may be refunded (partially or completely), this consideration is classified as variable consideration. After receiving potentially-refundable consideration, institutions must recognize a refund liability for the amount which they have received but expect to refund. When recognizing revenue for these types of transactions, institutions should exclude any refundable portions that they expect will be returned to the customer.
Based on the guidance in ASC 606-10-32-11, institutions should only include variable consideration in the transaction price to the extent to which “it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur.” ASC 606-10-32-12 provides several factors that institutions can use to assess the likelihood and magnitude of a potential revenue reversal.
FinREC believes that a significant reversal may not be expected if the institution has experience in predicting student withdrawals and the uncertainty surrounding student withdrawals will be resolved in a short time frame. Although institutions may struggle in determining whether an individual student will withdraw, they may be able to estimate withdrawals on the portfolio level (see #5). In such circumstances, FinREC suggests that institutions include estimates for withdrawals in the transaction price.
At the end of each reporting period, institutions must re-measure the size of the refund liability, adjust for updated estimates of variable consideration, and recognize the resulting impacts as additions or reductions to revenue.
10. Allocating the Transaction Price to Performance Obligations
The transaction price should be allocated to different performance obligations within the same contract based on relative standalone selling prices. ASC 606-10-32-32 explains that the “best evidence of a standalone selling price is the observable price of a good or service” sold separately to similar customers in similar circumstances.
Educational institutions regularly sell tuition separately from other services, but they rarely provide housing services to non-students. As a result, the tuition price is an observable standalone selling price, but the housing prices may not be. Institutions may need to estimate the standalone housing price by comparing similar housing arrangements provided by other entities in the local community. For more information about estimating a standalone selling price when an observable price is absent, see paragraphs 33-35 of ASC 606-10-32. (For more information on this topic see our Standalone Selling Prices and Case Study: Estimating Standalone Selling Prices articles.)
11. Timing of Revenue Recognition
Under ASC 606, revenue can be recognized at a point in time or over time. The timing of revenue recognition corresponds with how the associated performance obligations are satisfied. If the performance obligations are satisfied at a point in time, then revenue is recognized at a point in time. If the performance obligations are satisfied over time, then revenue is recognized over time.
Per ASC 606-10-25-27, entities satisfy performance obligations over time if a customer simultaneously receives and consumes the benefits related to a performance obligation. Most educational institutions provide instructional and housing services throughout an academic period. FinREC believes that students simultaneously receive and consume the benefits associated with these services. As such, FinREC believes that revenue from these services should be recognized over time. (For more information on this topic see our Revenue Recognition over Time article.)
If revenue is recognized over time, institutions must measure progress towards the satisfaction of the performance obligations using an input method or an output method. (For more information on this topic see our Input vs. Output Methods article.) Institutions should carefully consider which measure is most appropriate in the context of the transaction. Since instruction and housing services are provided evenly throughout an academic period, FinREC believes that institutions should use the input method of time elapsed for these services and recognize revenue ratably over the academic period.
If students have made nonrefundable prepayments, the institution should derecognize the contract liability associated with these prepayments (and recognize revenue) when (or as) the promised goods or services are transferred to the students. The nonrefundable prepayment is included in the total transaction price and recognized along with the other revenue generated by the contract. If the nonrefundable prepayment relates to a 6-month housing contract and the institution recognizes the revenue from the contract ratably over the period, the institution will derecognize the contract liability and recognize revenue evenly over the 6-month period. (For information about recognizing revenue related to nonrefundable prepayments where the student does not receive services from the entity, see topic number 2.)
In addition to providing a revenue recognition framework, ASC 606 requires specific financial statement presentations relating to revenue. The example in paragraphs 285 and 286 of ASC 606-10-55 show that entities must recognize a receivable (and a corresponding contract liability) if contracts become non-cancellable. Educational not-for-profit institutions should evaluate at what point enrollment contracts become non-cancellable, but this would generally be after the expiration of a student withdrawal period.
In a manner similar to customer prepayments, not-for-profit entities should recognize a contract asset if they provide services to customers before receiving payment. FinREC believes that the services provided should be recognized as contract assets, excluding amounts that are presented as a receivable. Any impairment to the contract asset must be measured, presented, and disclosed.
When a receivable from a contract with a customer is first recognized, any discrepancy between the receivable amount and the revenue previously recognized should be accounted for as an expense. When presenting revenues, ASC 606 prohibits the presentation of revenue from a contract on a gross basis. However, FinREC believes that not-for-profit institutions may disclose the amount of reductions included within the revenue parenthetically or in the notes to the financial statements.
13. Bifurcation of Contribution and Exchange Components
Many not-for-profit organizations receive generous payments for provided goods or services because the payments are partially intended to be contributions to the organization. These types of transactions where the consideration received by the entity is substantially higher than the value provided are classified as inherent contributions in the FASB ASC Master Glossary. Common examples of inherent contributions often include membership dues, naming rights, donor recognition, and other awards.
ASC 606-10-55 provides additional clarification about how to determine whether a transaction is a contribution, an exchange for provided services, or both. For contracts with both contribution and exchange elements, the transaction must be bifurcated. The revenue standard encourages practitioners to use the separation and measurement guidance from other relevant Topics listed in ASC 606-10-15-2 (leases, derivatives and hedging, etc.), if applicable.
Not-for-profit institutions should use the guidance in paragraphs 9-12 of ASC 985-605-55. Based on this guidance, FinREC believes that not-for-profit entities should first determine the fair value of the exchange portion of the transaction and treat the residual amount as a contribution.
ASC 606 introduces new rules, definitions, and concepts relating to contract identification, performance obligations, collectability, variable consideration, and more. Given their altruistic missions, not-for-profit entities should pay close attention to transactions involving the beneficiaries of the organization. To help navigate these complex relationships and transactions, we encourage you to carefully analyze your contracts using the resources referenced herein.