In contracts with customers, an entity should recognize revenue in a way that depicts the amount and timing of consideration received for transferring goods or services (Accounting Standards Update 2014-09 p. 2). To achieve this, an entity should apply the five-step approach outlined in the new revenue standard:
- 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 entity satisfies a performance obligation
This article summarizes each of the five steps and identifies key issues entities need to consider when completing each step. Our discussion of each issue is only a summary of issues public filers need to consider. To read analysis and see examples on each issue, many of the sections are linked to separate articles that address each given topic.
Step 1: Identify the contract with a customer
The new revenue guidance defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. Standard setters identified the attributes below as essential parts of a contract:
- All parties have approved the agreement. This criterion addresses the fact that a contract is usually only enforceable once all parties have approved it. Contracts may be written, oral, or implied by the entity’s normal business practices. Since contract enforceability is a matter of law, an entity should consider the legal jurisdiction in which it operates as the rules for contract enforceability may differ (e.g., some jurisdictions may require written contracts).
- All parties are committed to fulfilling their obligations. Termination clauses must be evaluated when addressing this criterion. The standard states that if each party has the unilateral right to terminate a wholly unperformed obligation, then no contract exists.
- Each party’s rights are identifiable. The arrangement must clearly identify the goods or services to be provided. If the performance obligations cannot be identified, then it is impossible to determine when the transfer of control has occurred, which is prerequisite for recognizing revenue.
- Payment terms are identified. As long as there is an enforceable right to receive payment in exchange for goods or services, the transaction price does not need to be expressly stated in the contract. The contract does need to include sufficient detail that the price can be reasonably estimated. When determining if payment terms are identified, the entity should consider if there are any laws or legal precedents that the customer could use to override the contractual obligation to pay.
- The contract has commercial substance. A contract only exists if the risk, timing, or amount of cash flows to an entity are expected to change as a direct result of the contract.
- Collectibility is probable. The new standard requires vendors to evaluate a customer’s credit risk at contract inception. Consistent with current guidance, a vendor can only recognize revenue when payment is likely to be received. For more information, see our article on Collectibility.
Filers should consider the following issues when addressing Step 1:
Consideration Received When a Contract Does Not Exist
When a vendor receives payment for an agreement that does not qualify as a contract, the vendor may only recognize revenue when one of the two following events occurs (Accounting Standards Codification 606-10-25-7):
- The agreement has been terminated and the payment received is nonrefundable
- The vendor does not owe any goods or services to the customer, and all, or substantially all, of the transaction price has been received and is nonrefundable
We summarized an example from ASC 606 to illustrate this point: A real estate developer enters into a contract to sell a building to a customer who plans to open a restaurant. The developer receives a nonrefundable deposit, and the remaining amount owed will be paid over time from the restaurant’s revenues. There is significant risk that the remaining amount will not be collected, so a contract does not exist. As such, the nonrefundable upfront deposit is not recognized as revenue until substantially all of the consideration is received or the restaurant closes down (termination of the contract). The full example is found in ASC 606-10-55-95 through 98.
The new standard requires a vendor to combine multiple contracts with the same customer into one contract when they are entered into at or near the same time and meet at least one of the criteria below (ASC 606-10-25-9):
- Contracts are negotiated as a single package with one business objective
- The payment amount for one contract is dependent on the performance of the other contract
- At least some of the promised goods or services in the contracts are a single performance obligation
The ASC 606 requirement for combining contracts is consistent with ASC 605, thus companies should reach similar conclusions regarding combining contracts under both topics. Unlike ASC 605, ASC 606 gives vendors the option to use the portfolio method. This permits vendors to combine contracts that would otherwise not be combined in order to simplify the revenue recognition process. This is only permitted as long as the result is not materially different from accounting for each contract individually.
Parties to a contract may change the transaction price and/or the scope of the contract (i.e., modifying the enforceable rights and performance obligations of each party). These changes may be accounted for as a separate contract or a modification to the existing contract depending on the circumstances, which in turn may alter the timing of revenue. A modification is a separate contract if (1) additional distinct goods or services are included, and (2) the transaction price increases by an amount that is comparable to the standalone selling price of the additional goods or services (ASC 606-10-25-12).
Step 2: Identify the performance obligations in the contract
A performance obligation is a promise to transfer goods or services to a customer. This step requires an entity to identify all distinct performance obligations in an arrangement. A good or service is distinct when (1) the customer can benefit from the good or service on its own or with resources the customer already has access to, and (2) the good or service can be transferred independent of other performance obligations in the contract (even if it is transferred with other goods or services). Goods or services that are not considered distinct should be combined with other goods or services until the bundle is distinct. See our article, Distinct Within the Context of a Contract.
The standard directs entities to consider performance obligations that are explicitly outlined in the contract as well as any obligations the customer may expect because of established business history. For example, if a vendor has always provided free shipping on goods to a client such that the client expects the goods it purchases to be delivered for free, then the shipping represents a performance obligation—even if it is not expressly stated in the contract. Administrative tasks, such as signing a contract or activating telecom services, do not transfer a good or service and should not be considered a performance obligation.
The following issues may affect an entity’s evaluation of performance obligations:
When other parties are involved in providing goods or services to an entity’s customer, the entity must determine whether its performance obligation is to provide the good or service itself (the principal) or to arrange for the other party to provide the good or service (the agent). This determination will affect the amount of revenue that the entity recognizes. If the entity is the principal, it will recognize the gross amount received from the customer as revenue. If the entity is the agent, it will only recognize the amount of the fee or commission that it receives for facilitating the sale. Identifying the correct performance obligation in Step 2 is critical to correctly recognizing revenue in principal vs agent situations.
The new standard distinguishes two different types of warranties, which are accounted for differently:
- Assurance-type warranty – this warranty only guarantees that the good or service functions as promised. It is not a distinct performance obligation.
- Service-type warranty – some warranties provide benefits beyond what assurance-type warranties offer. These warranties create a distinct performance obligation.
Many contracts provide the customer with options for additional goods or services such as discounted contract renewals or customer loyalty points. A customer option is a distinct performance obligation if the option provides a material right to the customer. There are no bright lines that define what makes a right material; however, the right must be more significant than any discount that would be available had the customer not entered into the contract with the entity.
Nonrefundable upfront fees can result in a distinct performance obligation in the same way as customer options. For example, health clubs may charge an upfront membership fee when a customer signs up and then not require the fee when the customer renews the one-year contract. Because the second year can be purchased at what is a discount compared to the first year, a material right is created and should be accounted for as a distinct performance obligation.
Some entities may, through contract specifications or through customary business practices, have an obligation to stand ready to provide goods or services to a customer. An example of such an obligation is a health club that has the obligation to have the services ready any time its members desire to use them. Revenue received for stand-ready obligations is recognized over the period of time an entity offers the stand-ready service.
When a company sells a product with a right of return, it is obligated to accept the product should it be returned. A right of return is not a distinct performance obligation, but adds variability to the transaction price. Thus, rights of return should be considered when evaluating variable consideration.
Step 3: Determine the transaction price
The transaction price is the amount of consideration an entity expects to be entitled to for transferring promised goods or services. The consideration amount can be fixed, variable, or a combination of both. The transaction price is allocated to the identified performance obligations in the contract. These allocated amounts are recognized as revenue when or as the performance obligations are fulfilled.
An entity excludes any future options for a contract from consideration when determining the transaction price. The entity also excludes amounts third parties will eventually collect, such as sales tax, when determining the transaction price.
The transaction price is easy to determine when a fixed amount of cash is received simultaneously with the transferred goods or services. Other situations require more judgment, such as the situations listed below:
Consideration is variable when the amount of consideration is subject to change due to timing, performance, or other factors. Variable consideration can come from discounts, rebates, refunds, credits, incentives, and other similar items. The transaction price is an estimate of the amount of consideration the entity expects to receive. In cases where there is uncertainty about the consideration amount, a constraint on that consideration must also be contemplated.
When the timing between receiving consideration and transferring goods or services is more than a year, a contract may have a significant financing component. A financing component in the transaction price considers the time value of money. This requirement ensures that entities recognize revenue at the amount that reflects the cash payment that the customer would have made at the time the goods or services were transferred to them (cash selling price), rather than significantly before or after the goods or services are provided.
Sometimes a customer will pay in the form of goods, services, stock, or other noncash consideration. The fair value of the noncash consideration is included in the transaction price. If fair value is not determinable, the standalone selling price of the goods or services transferred is used.
Some contracts require an entity to make payment(s) to a customer. Common examples include slotting fees, cooperative advertising, buydowns, price protection, coupons, and rebates. In most cases, payment to a customer reduces the transaction price (reducing the revenue recognized), but in some cases may be a purchase (expense) from the customer.
Common examples of nonrefundable upfront fees include fees paid for a membership or an activation fees for services such as the internet. These fees are paid in advance for the right to a service or good in the future without a guarantee for the payment to be returned. An entity must decide if the fee relates to a specific future transfer of goods or services and decide if the fee represents a renewal option at a reduced price.
Step 4: Allocate the transaction price
When a contract includes more than one performance obligation, the seller should allocate the total consideration to each performance obligation based on its relative standalone selling price. The seller must estimate the standalone selling price if it is not observable. ASC 606 does not prohibit any method for estimating the standalone selling price, as long as the estimation is an accurate representation of what price would be charged in a separate transaction. The standard does mention three acceptable methods: adjustment market assessment, expected cost plus margin, and residual. These methods are discussed in Standalone Selling Prices.
If there are multiple performance obligations in a contract, the seller must determine if there is any variable consideration or discounts. Variable consideration and discounts should only be allocated to the performance obligations they are related to.
When the scope and/or transaction price is changed, the modification is accounted for as a separate contract or a change to the existing contract, depending on the circumstances as noted above. If the contract is accounted for as a change to the existing contract, the changes should be allocated to each performance obligation according to the same method used at the contract’s inception.
Step 5: Recognize revenue when or as performance obligations are satisfied
The final step in applying the new revenue recognition standard is to recognize revenue when or as the performance obligations in the contract are satisfied. For performance obligations that are fulfilled at a point in time, revenue is recognized at the fulfillment of the performance obligation. For performance obligations satisfied over time, an entity must decide how to appropriately measure the progress and completion of the performance obligation.
A performance obligation is satisfied when or as control of the good or service is transferred to the customer. The standard defines control as “the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.” (ASC 606-10-20). Here are several issues that companies should consider in applying step 5 of the standard:
Companies are required to determine if each performance obligation is satisfied over time. Any obligations that are not satisfied over time are assumed to be satisfied at a point in time. An obligation is satisfied over time if it meets any of the following criteria:
- The customer simultaneously receives and consumes the benefit provided by the entity as the entity performs
- The entity’s performance creates or enhances assets that the customer controls while the assets are being created/enhanced
- The performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date
When a performance obligation is satisfied at a point in time, companies must determine when control is transferred to the customer in order to determine when revenue should be recognized. The standard provides several examples of indicators that the transfer of control has occurred; these and similar indicators should be considered in determining when to recognize revenue.
When a performance obligation is satisfied over time, companies must determine whether using an input or output measure better represents the satisfaction of the performance obligation. The output method measures progress by the results achieved, such as the miles of train tracks completed. The input method measures progress based on the materials consumed in production, like the number of railroad ties used.
The standard favors the output method because it tends to better reflect the transfer of goods and services to the customer. However, the standard allows filers to use an alternative method when it better represents the transfer of goods and services.
The standard provides several examples of performance obligations in 606-10-25-18. Promises by an entity to stand ready to perform a service or transfer a good can sometimes constitute performance obligations. In these cases, filers need to determine if it is appropriate to recognize revenue on a straight-line basis or use another method.
Consignment is when a company transfers its goods to an intermediary for sale to the end user. In consignment arrangements, revenue should not be recognized until control is transferred from the company to either the intermediary or to a customer through the intermediary.
As opposed to consignment arrangements, in bill and hold arrangements, a customer has purchased goods from a company and requested that the company retain the goods until the customer is ready to receive the goods. Prior to ASC 606, companies that reported bill and hold transactions did so using a long list of criteria found in SEC SAB 13. The new standard includes similar criteria, but significantly simplified for application. The determination of bill and hold status will require more judgment, but the end result is expected to be the same for the majority of transactions.