“The joint task force of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) finalized its project to develop a common revenue recognition standard on May 28th, 2014, when the FASB and IASB issued Accounting Standards Update (ASU) 2014-09 and IFRS 15, respectively (“the Standard”).”~Business Review of St. Johns University

If you are not familiar, the FASB and the IASB began working the new revenue recognition standard as a joint project in 2002. The goal was to converge International Accounting Standards with US Generally Accepted Accounting Principles (GAAP). The current global business environment demands an increase in revenue recognition comparability through a consistent and robust framework across all entities in different industries and different countries.

Current Revenue Recognition Standards: Risks and Rewards

The current standards for revenue recognition under U.S. GAAP states: “Revenue can only be recognized if it is 1) realized or realizable, and 2) earned.” This risks and rewards approach stipulates that revenue to the company gets realized and earned (recognized) when the risks and the rewards of ownership gets transferred to the customer, and the seller no longer has control. Sounds like a no-brainer. The company makes a product. They sell the product. The customer takes it away. Revenue gets recognized. However, it is not that simple.

What if a company sells a product to a client but some of the risks of the product remain with the entity? The accountants would assess the situation based on “risks and rewards” and might conclude that one part of the performance obligation gets completed thus revenue gets recognized. The next step is to look to see if “control” (thus risk) has ceded. If what gets sold had a fixed price maintenance agreement or was a contract for monthly access or service, then those performance obligations have not been satisfied.

The New Revenue Recognition Standard: Contracts and Controls

The Accounting Standards Update gets based on the control approach. Control defined is the ability to direct the use of and obtain all of the remaining benefits from the asset substantially. The boards realized that the current standards fail to account for variables that might interfere with completing the risks and rewards transfer. To further defend their position, the board provided and assertion paragraph BC118 of the ASC.

An Example Based on Paragraph BC118 of the ASC:

If a telecommunications company promises a bundle of goods and services such as a 1) subsidized phone and 2) a uncancellable service contract for fixed consideration. The new standards revenue recognition of the bundle gets accelerated compared to current revenue recognition guidance. In particular revenue allocation to the delivery of the phone will increase and then will then decrease as the obligations under the contract lesson.

In this case, the requirement is the company must identify a customer contract “and assign the transaction price to performance obligations embedded in the contract.” Revenue gets recognized when or as a performance requirement gets satisfied. When the control gets transferred to the customer the requirement gets satisfied. The new standard applies to all entities and replaces most industry-specific guidance. While there are still minor differences between IFRS and U.S. GAAP, for US companies it is wise to follow specific requirements under U.S. GAAP.

The Initial Year of Adoption

The effective dates vary for the type of entity and by reporting period. However, there are standard requirements for the initial year of adoption. There are choices between immediately adopting the new standard or implementing a modified transition approach. “The modified transition approach requires entities to apply the new revenue standard to contracts not completed as of the date of adoption and to record a cumulative adjustment to beginning retained earnings in the year of adoption.”

The required approach of the new model has five steps:

Step 1: The contract with a customer gets identified. A contract must have economic substance, be approved by all parties committed to performing their obligations, all rights and payment terms are identifiable, and it is probable that the entity will collect the considerations in exchange for the goods or services. Revenue does not get recognized from a contract that fails to satisfy all the criteria outlined in the contract.

Step 2: Individual performance obligations in the contract get identified. Performance requirements are distinct, if not, they become a separate bundle. The New Standard states performance requirements are independent if both “1) the promise to transfer the good or service is separable from other obligations in the contract and 2) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the client.”

Step 3: The transaction price under the contract gets identified. The price gets fixed. The price also can vary based on discounts, refunds, credits, rebates, incentives, contingencies performance penalties or bonuses or by a price concession. If the entity has enough evidence to support the amounts involved variable consideration can get used, if no possibility of significant reversal exists. The steps involved to find the transactions price include:

  1. Estimate the variable consideration amount using probability weighted approach or a single most likely number.
  2. The sale price gets based on the entitled amount the entity expects regardless of risk.
  3. Non-cash consideration in exchange for promised goods and services get measured at fair value.
  4. If the entity cannot reasonably estimate the fair value, it gets measured indirectly by reference “to the standalone selling prices of the goods and services.”

Step 4: Separate performance obligations prices get broken down. The entity must break-out the allocation based on a relative standalone price. However if the goods do not get sold separately, required is an estimate of the selling price. The usual approach is the expected cost-plus a margin approach, the adjusted market assessment approach, or the residual approach.

Step 5: When or as the performance obligations get satisfied, recognize revenue. The performance requirement either meets the criteria of satisfied over time or satisfied at a point in time.

The over time indicators are:

  1. The output method is a direct measurement of value to the customer of the goods and services. However, this often is difficult to measure without unnecessary costs.
  2. If the entity can not reasonably gauge the outcome of the performance obligation, then the input method gets used. An entity should not recognize revenue on goods and service when a return or refund may materialize. An example is the accrual of warranty obligations.

The point in time indicators are:

  1. The entity is presently entitled to payment.
  2. The legal title belongs to the customer.
  3. Physical possession of the asset gets transferred.
  4. The risk and rewards of ownership now rest with the customer.
  5. Acceptance by the customer is apparent.

Depending on the type of entity and the accounting methods used the new revenue recognition standard will be in effect as early as December 15, 2016, and as late as December 15, 2018. Staying current on this new standard is highly recommended, and it is always best to get the needed information from the correct governing body.

Additionally, there is no better way to get started and be prepared for this change and others that might be coming than by updating your accounting system. The Intacct best-in-class cloud ERP solution streamlines operations and provides real-time insights, boosting productivity and growth and can seamlessly manage all your revenue recognition needs.

In fact, last quarter was monumental for Intacct with the launch of Intacct Contract and Revenue Management—the industry’s first automated solution designed to help companies navigate the complexities created by the upcoming ASC 606 and IFRS 15 revenue recognition guidelines.

Fast-growing businesses choose Intacct to automate subscription management and complex revenue accounting while delivering deep insights into financial and operational outcomes.

Find out more by contacting InCloud 360 today. This content was originally posted here.

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The new ASC 606 and IFRS 15 accounting standards—some of the most far-reaching changes to accounting since Sarbanes-Oxley—are only a few quarters away. Get ASC 606 Resources such as news, assets, and learn about the advantages Intacct provides in helping you address these changing rules with Intacct Contract Revenue Management and Contract and Subscription Billing.