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  • Accounting

5 Criteria for Revenue Recognition

Kyle Hofeldt, Audit Director
October 19, 2018
5 Criteria for Revenue Recognition

ASC 606 is effective for January 1, 2019, for all fiscal year-end companies. This means some companies which are materially affected will have to determine the effect of this standard over the coming months.

The core principle to follow for revenue recognition under the new standard is transfer of control and not risks and rewards of ownership as was done with legacy GAAP. ASC 606 also eliminates industry-specific guidance and replaces it with a principles-based approach. To administer this, companies can apply a five-step process of recognition.

 

1. Identify the Contract with Your Customer

A contract with a customer has several elements, but the most overlooked element may be that the contract does not have to be in writing. It does need to have:

  • Commercial substance
  • Parties who are committed to satisfying the obligations
  • Identifiable rights and payment terms
  • Probable collection

 

2. Identify Your Performance Obligations

What is a contract? It is identified as a good or service and must be accounted for as a separate performance obligation for the company only if it is distinct. This means that your customer can benefit from the good or service on its own (or with readily attainable resources) and that the promise to transfer the good or service is separate from other promises in the contract. Contracts can have single or multiple performance obligations.

 

3. Determine Your Transaction Price

Several considerations affect your transaction price, including:

  • Variable consideration such as discounts, credits, incentives, or price concessions
  • Changes in transaction price over the life of the contract, which should be allocated in the same manner as at contract inception
  • Customer rights of return and rebates which can create variable consideration. Customer history must be looked at for these determinations

While keeping these aspects in mind, only the consideration you actually expect to receive is recorded as revenue.

 

4. Allocate the Transaction Price to the Performance Obligations in the Contract

For multiple performance obligations, the company should determine at contract inception how the consideration will be allocated. This can be based on the standalone price of the obligations, or estimated by the company based on past experience.

 

5. Recognize Revenue When Your Business Satisfies a Performance Obligation

The most important factor here is whether revenue is recognized at a “point in time”, or “over time”.  If obligations are satisfied over time, either the input or output method should be used to measure progress.

 

Industry Highlights

Construction

Overall most of the effect will be term changes; however, disclosure changes may be substantial. The areas construction companies will need to watch are major contract adjustments and unpriced change orders to determine if a new contract is created; any significant costs incurred to obtain the contract; the potential of having uninstalled materials; you may also need to consider whether large penalty clauses create variable consideration.

 

Technology

Multiple element arrangements (licenses, support, and maintenance) are likely to be considered distinct and therefore individual contracts. Renewal option discounts and service discounts can create variable consideration and affect revenue. You'll need to take closer looks at variable consideration in the contract at inception to determine the most likely amount to be collected.

 

Franchisors

Most franchise fees will now be recognized over time as opposed to contract inception. You'll need to determine how many distinct revenue streams you have, and distinguish symbolic IP (ex: trademarks) from functional IP (ex: software). Symbolic IP is recognized over time while functional IP at a point in time.

 

NFP

For the most part, NFP revenue remains under legacy GAAP standards. Any non-reciprocal transactions will be subject to ASC 606 recognition criteria.

 

Special Considerations

There are a few topics that deserve special considerations.

  • Warranties may create separate performance obligations depending on their type
  • Upfront fees such as setup, access, initiation, and membership fees are recognized over the contract unless a performance obligation is immediately satisfied.
  • Sales commissions are amortized over the life of the contract.
  • Gift cards are recognized when redeemed.
  • Licenses such as software, patents, trade names, franchise names and rights to access and use (IP addresses in particular) may be recognized over time or at use grant date depending on the type of license.

 

Financial Statement Disclosures

All companies will be affected by ASC 606 when it comes to financial statement disclosures. At a minimum, companies must now provide disclosures about point in time vs. over time revenue, contract assets and liabilities, and any impairment losses expected to be incurred. Expanded disclosure of the company’s revenue recognition policies, including terms of payment, nature of goods, significant judgments or estimates, obligations of returns/refunds, warranties, and other items affecting its revenue will be required.

Companies may elect a full retrospective presentation, in which the entire set of financial statements is restated, or a modified approach that will only restate equity the year of adoption. If you have any questions, please contact us or learn more on this topic by visiting our accounting blog.

  • Competition, Adaptability, Achiever, Strategic, Command

Kyle Hofeldt

Audit Director
Kyle Hofeldt serves as an Audit Director at Lutz with over ten years of assurance and consulting experience. He specializes in providing accounting, auditing and consulting services to privately-held companies in various industries including agriculture, service, manufacturing, construction, technology, and transportation.

402.492.2128

khofeldt@lutz.us

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