Summary
On November 14, 2011, the FASB and IASB jointly issued a revised exposure draft, Revenue from Contracts with Customers. The guidance revises the initial exposure draft on this topic issued in June 2010 and would supersede the majority of current revenue recognition guidance. The objective of the exposure draft is to clarify existing revenue recognition principles and develop a common standard for US GAAP and IFRS. This includes removing inconsistencies and perceived weaknesses in existing revenue standards, and also improving the comparability of revenue recognition practices across companies, industries and capital markets.
Scope, Effective Date and Transition: The exposure draft is applicable to all entities that enter into contracts with customers unless those contracts are within the scope of other standards. The effective date of the proposal would not be before January 1, 2015 for public entities with a minimum one year deferral period expected for non-public entities. Early adoption is not permitted by the FASB’s proposal; however, the IASB plans to permit early adoption. Retrospective application is required under the exposure draft, although certain transition relief is available.
Proposed Model: The proposed model is built on the contract between a vendor and a customer for the provision of goods and services. It attempts to depict the exchange of rights and obligations between the parties in the pattern of revenue recognition based on the consideration the vendor receives. To accomplish this objective, the guidance requires the application of the following five steps:
- Identify the contract with the customer.
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the separate performance obligations in the contract.
- Recognize revenue when (or as) the company satisfies a performance obligation.
Identify the contract
The proposal applies to all oral, written or implied contracts with all of the following characteristics:
- The contract has commercial substance.
- The company and customer have approved the contract and are committed to performing under the contract.
- The company can identify each party’s rights with respect to the goods or services to be transferred.
- The company can identify the payment terms with respect to the goods or services to be transferred.
These provisions are generally applied to each individual contract with a customer. However, if certain criteria are met, separate contracts with the same party entered into at or near the same time must be combined under the proposed guidance. Contracts are to be combined and accounted for as a single contract if 1) they are negotiated with a single commercial objective, 2) the consideration paid in one contract is dependent on another contract or 3) the goods or services to be provided under the contracts represent a single performance obligation (i.e., they are not “distinct” as described below).
The proposed guidance also addresses contract modifications. A contract modification would be accounted for as a separate contract if 1) it includes a separate performance obligation and 2) the additional consideration paid reflects the company’s stand-alone selling price for that performance obligation. If these criteria are not met, the modification is accounted for as an adjustment to the original contract. Depending on the circumstances, the modified contract (i.e. the adjustment) would be allocated to the remaining performance obligations on a prospective basis or reflected as a cumulative catch-up adjustment to revenue, whether positive or negative.
Identify the separate performance obligations
The exposure draft defines a performance obligation as a contractual promise to deliver a good or service to the customer. Each promised good or service is treated as a separate performance obligation if it is “distinct.” A good or service is distinct if it is regularly sold separately or the customer benefits from the good or service by itself or together with resources that are readily available to the customer.
Nevertheless, the proposal requires a bundle of distinct goods or services to be combined and treated as a single performance obligation if the goods and services in the bundle are 1) highly interrelated and the company provides a significant service of integrating the goods or services into the combined item and 2) modified or customized to fulfill the contract. The proposal does not define “highly interrelated,” but it does provide illustrations. As such, judgment will be required to determine when performance obligations are considered highly interrelated.
Determine the transaction price
A contract’s transaction price is the amount of consideration to which a company expects to be entitled in exchange for the promised goods or services. The transaction price can be a fixed or variable amount. The proposal contains guidance for variable consideration, the time value of money, noncash consideration and consideration payable to a customer when determining the appropriate transaction price.
A contract’s consideration can vary for a variety of reasons including discounts, rebates, refunds, performance bonuses, etc. If the consideration is variable, a company would estimate the transaction price using one of two methods:
- The expected value method – consideration is equal to the sum of probability weighted amounts in the range of total possible consideration, or
- The most likely amount method – consideration is the single most likely amount in the range of possible amounts.
The method selected depends on the approach that is deemed more predictive. For example, it would be appropriate to estimate the most likely amount when the customer either will, or will not, pay an amount based on a contingency in the contract. As such, practitioners can conclude that a probability weighted amount will not be paid because the outcome is binary. That is, either the contingency will be met and the full amount will be paid or the contingency will not be met and no consideration will be paid.
When determining the transaction price, a company would not consider the effects of customer credit risk (i.e., collectibility). Instead, a company would account for customer credit risk by applying the provisions of ASC 310, Receivables, or IAS 39, Financial Instruments: Recognition and Measurement (or IFRS 9, Financial Instruments, if the company has adopted IFRS 9). Any corresponding amounts recognized in profit or loss for collectability would be presented as a separate line item on the face of the income statement adjacent to revenue. In other words, these amounts will be presented as contra-revenue rather than in SG&A.
Payments that a company makes (or expects to make) to its customer are treated as a reduction of the company’s transaction price unless the payment is in exchange for a “distinct” good or service, as described above.
Allocate the transaction price
For contracts with more than one performance obligation, a company must allocate the transaction price on a relative stand-alone selling price basis. The best evidence of stand-alone selling price is the observable price at which the good or service can be sold separately. If an observable price is not available, the stand-alone price must be estimated. In other words, it is not appropriate to combine distinct performance obligations because of the difficulty in estimating stand-alone sales prices.
The exposure draft provides several examples of estimating the selling price. These include a market-based approach, an expected cost plus margin approach and a residual approach. The residual approach may only be used if the stand-alone price is highly variable or uncertain, although it applies to any performance obligation, whether delivered or undelivered.
Any changes to the transaction price subsequent to contract inception are generally allocated to all performance obligations on the same basis as at inception. However, in limited circumstances, the change is allocated to one or more specific performance obligations, rather than ratably to all of the obligations.
Recognize revenue
Revenue is recognized when the vendor satisfies each performance obligation. Obligations are satisfied when the vendor transfers control to the customer, which occurs when the customer can direct the use of and has the ability to benefit from the promised good or service. The proposal does not define the notion of control. Instead, it provides indicators for assessing when control has transferred. In addition, companies will need to exercise judgment to determine if the performance obligations are transferred over a period of time, or at a single point.
One of the following two criteria must be met for control to transfer over time:
- The company’s performance creates or enhances the asset controlled by the customer (e.g., work in process), or
- The company’s performance does not create an asset with alternative use and one of the following criteria is met:
- The customer simultaneously receives and consumes benefits
- If another company was hired to perform the remaining obligation, it would not need to substantially reperform the work already completed by the company
- The company has the right to payment for performance completed and expects to fulfill the contract as promised.
If the company determines that control is transferred continuously, the corresponding revenue would be recognized over time by using an input or output method for measuring progress toward completion. Input methods include resources consumed, labor hours expended, costs incurred, etc. Output methods are generally more visible to the customer and include milestones reached or units produced, etc.
When control is transferred at a point in time, rather than continuously, some key indicators of when revenue should be recognized are listed below. Note, no individual factor is determinative, nor is the list all-inclusive:
- The company has payment rights for the asset.
- The customer has title to the asset.
- Physical possession of the asset has been transferred to the customer.
- The customer bears the risks and rewards of ownership for the asset.
- The customer has accepted the asset.
As a constraint on the general principle of recognizing revenue when control is transferred, variable consideration associated with a performance obligation that has been satisfied is only recognized when the company is reasonably assured to be entitled to that amount. Companies will be required to exercise judgment to make that determination based on their experience with similar contracts, and that experience is still considered predictive.
Other key areas: The exposure draft includes specific guidance related to several additional topics, some of which are discussed below:
- Onerous performance obligations
- Contract costs
- Sale with a right of return
- Warranties
- Principal vs. agent considerations
- Customer options for additional goods and services
- Customers unexercised rights
- Nonrefundable upfront fees
- Licensing and rights to use
- Repurchase agreements
- Consignment arrangements
- Bill-and-hold arrangements
- Customer acceptance
Onerous performance obligations
For performance obligations that, at inception, are expected to take more than one year to satisfy, entities must assess whether the performance obligations are onerous. That condition exists when the lowest cost of settling the performance obligation exceeds the allocated transaction price. If the cost exceeds the remaining revenue to be recognized, a liability (and the corresponding expense) is recorded for the excess.
Contract costs
Under the proposed guidance, the incremental costs associated with obtaining a contract should be capitalized if those costs are expected to be recovered. Costs associated with fulfilling a contract are subject to other GAAP, if applicable (e.g., the standards for inventory or fixed assets). Otherwise, the costs associated with contract fulfillment are capitalized only 1) if the costs are directly related to the contract, 2) will generate or enhance resources of the company that will be used in satisfying performance obligations in the future, and 3) are expected to be recovered. Capitalized contract costs should be amortized over the period commensurate with the transfer of corresponding good or service. As a practical expedient, contract costs can be expensed as incurred if the expected amortization period is less than one year.
Warranties
Entities can continue to use the cost-accrual method for warranty obligations that only serve to ensure the product meets agreed-upon specifications. However, if the customer has the option to purchase a separate warranty with the product, the warranty should be treated as a performance obligation to which a portion of revenue must be allocated. If the warranty provides a service in addition to ensuring the good meets agreed-upon specifications, the service portion should be treated as a separate performance obligation.
Sale with a Right of Return
Many products are sold with a right of return. Under the proposed guidance, a company would recognize the following in such situations:
- Revenue based on the amount the company is reasonably assured to be entitled (considering the products expected to be returned)
- A refund liability for the portion expected to be repaid to the customer
- An asset (and adjustment to cost of sales) for the product expected to be recovered
The refund liability should be assessed at each reporting period for changes in expectations about the amount of refunds. Likewise, the asset is subject to an impairment assessment each period.
Disclosures: The proposed guidance significantly enhances the required qualitative and quantitative disclosures related to revenue. Some relief is available for private entities. These disclosure provisions are reproduced in Appendix A.
Comparison of the First and Second Exposure Drafts: The revised exposure draft reflects the FASB and IASB’s consideration of nearly 1000 comment letters received on the June 2010 draft, and extensive subsequent outreach efforts. The differences between the first and second proposals are summarized in Appendix B.
The exposure draft can be accessed here. Comments are due by March 13, 2012.
Appendix A - Disclosure Requirements
(reproduced from the Exposure Draft)
Disclosure
The objective of the proposed disclosure requirements is to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. To achieve that objective, an entity shall disclose qualitative and quantitative information about all of the following:
- Its contracts with customers (paragraphs 113–123)
- The significant judgments, and changes in the judgments, made in applying the proposed guidance to those contracts (paragraphs 124–127)
- Any assets recognized from the costs to obtain or fulfill a contract with a customer in accordance with paragraphs 91 and 94 (paragraphs 128 and 129)
An entity shall consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the various requirements. An entity shall aggregate or disaggregate disclosures so that useful information is not obscured by either the inclusion of a large amount of insignificant detail or the aggregation of items that have substantially different characteristics.
Amounts disclosed are for each period for which a statement of comprehensive income is presented and as of each period for which a statement of financial position is presented, as applicable, unless otherwise stated. An entity need not disclose information in accordance with this proposed guidance if it has provided the information in accordance with another Topic.
Contracts with customers
An entity shall disclose information about its contracts with customers, including all of the following:
- A disaggregation of revenue for the period (paragraphs 114–116)
- A reconciliation from the opening to the closing aggregate balance of contract assets and contract liabilities (paragraph 117)
- Information about the entity’s performance obligations (paragraphs 118–121), including additional information about any onerous performance obligations (paragraphs 122 and 123)
Disaggregation of revenue
An entity shall disaggregate revenue from contracts with customers (excluding amounts presented for customers’ credit risk) into the primary categories that depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors. To meet the disclosure objective in paragraph 109, an entity may need to use more than one type of category to disaggregate revenue.
Examples of categories that might be appropriate include, but are not limited to, the following:
- Type of good or service (for example, major product lines)
- Geography (for example, country or region)
- Market or type of customer (for example, government and nongovernment customers)
- Type of contract (for example, fixed-price and time-and-materials contracts)
- Contract duration (for example, short-term and long-term contracts)
- Timing of transfer of goods or services (for example, revenue from goods or services transferred to customers at a point in time and revenue from goods or services transferred over time)
- Sales channels (for example, goods sold directly to consumers and goods sold through intermediaries)
A nonpublic entity need not apply the proposals in paragraphs 114 and 115. Rather, a nonpublic entity shall disclose qualitative information about how economic factors (such as type of customer, geographical location of customers, and type of contract) affect the nature, amount, timing and uncertainty of revenue and cash flows. A nonpublic entity shall disaggregate revenue in accordance with the timing of transfer of goods or services (for example, revenue from goods or services transferred to customers at a point in time and revenue from goods or services transferred over time).
Reconciliation of contract balances (see paragraph IG75)
An entity shall disclose in tabular format a reconciliation from the opening to the closing aggregate balance of contract assets and contract liabilities. The reconciliation shall disclose each of the following, if applicable:
- The amount(s) recognized in the statement of comprehensive income arising from either of the following:
- Revenue from performance obligations satisfied during the reporting period
- Revenue from allocating changes in the transaction price to performance obligations satisfied in previous reporting periods.
- Cash received
- Amounts transferred to receivables
- Noncash consideration received
- Effects of business combinations
- Any additional line items that may be needed to understand the change in the contract assets and contract liabilities
Performance obligations
An entity shall disclose information about its performance obligations in contracts with customers, including a description of all of the following:
- When the entity typically satisfies its performance obligations (for example, upon shipment, upon delivery, as services are rendered, or upon completion of service)
- The significant payment terms (for example, when payment typically is due, whether the consideration amount is variable, and whether the contract has a significant financing component)
- The nature of the goods or services that the entity has promised to transfer, highlighting any performance obligations to arrange for another party to transfer goods or services (that is, if the entity is acting as an agent)
- Obligations for returns, refunds, and other similar obligations
- Types of warranties and related obligations.
For contracts with an original expected duration of more than one year, an entity shall disclose the following information as of the end of the current reporting period:
- The aggregate amount of the transaction price allocated to remaining performance obligations
- An explanation of when the entity expects to recognize that amount as revenue
An entity may disclose the information in paragraph 119 either on a quantitative basis using the time bands that would be most appropriate for the duration of the remaining performance obligations or by using qualitative information.
As a practical expedient, an entity need not disclose the information in paragraph 119 for a performance obligation if the entity recognizes revenue in accordance with paragraph 42.
Onerous performance obligations
An entity shall disclose the amount of the liability recognized for onerous performance obligations along with a description of all of the following:
- The nature and amount of the remaining performance obligation(s) in the contract that are onerous for which the liability has been recognized.
- Why those performance obligations are onerous.
- When the entity expects to satisfy those performance obligations.
An entity shall disclose in tabular format a reconciliation from the opening to the closing balance of the liability recognized for onerous performance obligations. The reconciliation shall include the amounts attributable to each of the following, if applicable:
- Increases in the liability from performance obligations that became onerous during the period
- Reductions of the liability from performance obligations satisfied during the period
- Changes in the measurement of the liability that occurred during the reporting period
- Any additional line items that may be needed to understand the change in the liability recognized
Significant judgments in the application of the proposed guidance
An entity shall disclose the judgments, and changes in the judgments, made in applying this proposed guidance that significantly affect the determination of the amount and timing of revenue from contracts with customers. At a minimum, an entity shall explain the judgments, and changes in the judgments, used in determining both of the following:
- The timing of satisfaction of performance obligations (paragraphs 125 and 126)
- The transaction price and the amounts allocated to performance obligations (paragraph 127)
Determining the timing of satisfaction of performance obligations
For performance obligations that an entity satisfies over time, an entity shall disclose both of the following:
- The methods used to recognize revenue (for example, a description of the output method or input method)
- An explanation of why such methods are a faithful depiction of the transfer of goods or services
For performance obligations satisfied at a point in time, an entity shall disclose the significant judgments made in evaluating when the customer obtains control of promised goods or services.
Determining the transaction price and the amounts allocated to performance obligations
An entity shall disclose information about the methods, inputs and assumptions used to:
- Determine the transaction price
- Estimate standalone selling prices of promised goods or services
- Measure obligations for returns, refunds, and other similar obligations
- Measure the amount of the liability recognized for onerous performance obligations
Assets recognized from the costs to obtain or fulfill a contract with a customer
An entity shall disclose a reconciliation of the opening and closing balances of assets recognized from the costs incurred to obtain or fulfill a contract with a customer (in accordance with paragraphs 91 and 94), by main category of asset (for example, costs to obtain contracts with customers, precontract costs, and setup costs). The reconciliation shall include amounts related to each of the following, if applicable:
- Additions
- Amortization
- Impairment losses
- Reversals of impairment losses [This subparagraph in the IASB’s Exposure Draft is not used in the FASB’s version of the proposed guidance.]
- Any additional line items that may be needed to understand the change in the reporting period
An entity shall describe the method it uses to determine the amortization for each reporting period.
Nonpublic entity disclosure
A nonpublic entity may elect not to provide any of the following disclosures:
- A reconciliation of contract balances (paragraph 117)
- The amount of the transaction price allocated to remaining performance obligations and an explanation of when the entity expects to recognize that amount as revenue (paragraph 119)
- A reconciliation of liability balances recognized from onerous performance obligations (paragraph 123)
- A reconciliation of asset balances recognized from the costs to obtain or fulfill a contract with a customer (paragraph 128)
- An explanation of the judgments, and changes in judgments, used in determining the timing of satisfaction of performance obligations (paragraphs 125 and 126) and in determining the transaction price and allocating it to performance obligations (paragraph 127)
Appendix B – Summary of Changes from the 2010 Proposed Update
(reproduced from the Exposure Draft)