Update published on June 5, 2020: FASB issued Accounting Standards Update (ASU) 2020-05, Revenue from Contracts with Customers (ASC 606) and Leases (ASC 842) Effective Dates for Certain Entities, as part of its efforts to support and assist stakeholders as they cope with the many challenges and hardships related to the COVID-19 pandemic.
Over four years have passed since the Financial Accounting Standards Board (FASB) issued its landmark revenue recognition guidance. Despite that time lag, many manufacturers and distributors have not yet started to seriously consider implementation steps. Entities should have already begun assessing how they will be impacted by the new standard in order to develop an appropriate implementation approach to ensure a smooth transition. This includes evaluating existing revenue contracts and accounting policies in order to identify potential changes that will result from adoption of the new standard. Even if you have not, it’s not too late to get started.
What are the key points of which all manufacturers and distributors should be aware?
Implementation dates of the new guidance:
Non-public entities: years beginning after December 15, 2018 (calendar year 2019)
Public entities: years beginning after December 15, 2017 (calendar year 2018)
Entities will need to go through the five-step process:
- Identify each good or service promised to a customer.
- Determine whether each good or service is a performance obligation.
- Determine the transaction price.
- Allocate the transaction price to each performance obligation.
- Recognize revenue when each performance obligation is satisfied.
Agreements Do Not Qualify as Contracts
An agreement does not qualify as a contract (and therefore may not be considered for revenue recognition) unless collection of amounts due from the customer is probable. This is different from current GAAP, which requires that collection must be “reasonably assured.” Collection focuses on a customer’s ability and intent to pay, and if there are changes in circumstances during the life of the contract, the contract will have to be reassessed. Such a reassessment could impact recognition of revenue on future goods and services to be transferred.
The new standard introduces the concept of a “performance obligation,” which is a promise to transfer a good or service that is distinct, or a series of distinct goods and services, to the customer. Going forward, the performance obligation – not the contract – is the unit of measurement for revenue recognition.
The new standard also introduces the concept of “variable consideration,” which includes claims, penalty or incentive provisions, change orders for which pricing hasn’t been determined, etc. Variable consideration may be included in the transaction price (ie: “contract value,” in today’s terms) if it is probable that a significant reversal will not occur upon resolution of the uncertainty. An entity must elect whether to use the expected value or most likely amount methods in determining the amount of variable consideration to consider in calculating revenue. A general rule of thumb is that “probable” means that the outcome has a 70-80% chance of occurring. Variable consideration will need to be assessed at each reporting period.
Many questions have been asked about variable considerations, so included below is an example of variable considerations related to a volume discount.
There are two transition options for implementation:
Full retrospective method, by which an entity adjusts its prior-year financial statement balances in the year of implementation.
Modified retrospective method, by which the cumulative effect of retrospective application is recorded at initial adoption.
There is now extensive disclosure requirements related to revenue recognition policies and results. These disclosures will provide financial statement users with quantitative and qualitative information regarding revenue recognition policies and how they are applied.
If you have questions about how to implement the new revenue recognition guidance or need a review of your implementation plan, please contact Pat Brown (email@example.com) or Ryan Graham (firstname.lastname@example.org).
Variable Consideration Example:
- A chemical company has a three-year contract with a customer to deliver high performance plastics.
- The contract stipulates that the price per container will decrease as sales volume increases during the calendar year as follows:
- Management believes that total sales volume for the year will be 2.5 million containers based on its experience with similar contracts and forecasted sales to the customer.
- If the volume discount coincides with the reporting period, unless there is some type of interim reporting required, the statements at the end of the period would be correct and the variable consideration would be known.
How should the chemical company consider the volume discount when recognizing revenue?
The company should first determine whether the volume discount provides the customer with a material right that it would not otherwise receive without entering into the arrangement. The evaluation of whether an option provides a material right requires judgment; the company should consider whether the volume discount offered to its customers is incremental to the range of discounts typically given to the same class of customer.
Assuming the chemical company concludes that the volume discount is a material right, it would account for the option as a separate performance obligation. The company should allocate the transaction price to the goods (high performance plastics) and the material right (option for discounted future services) based on their relative standalone selling prices.
The estimate of the standalone selling price of the option should reflect the discount, adjusted for any discount that the customer could receive without the option (standard discount off of list price) and an expectation of the likelihood of exercise. However, the standards also provide a practical alternative if the material right is for the purchase of goods similar to the original goods. The practical alternative would allow the company to allocate the transaction price to the optional goods by reference to the goods expected to be provided and the corresponding expected consideration (i.e., the discounted price), rather than estimating the standalone selling price of the material right.
Assuming the company elects to apply the practical alternative in this case, the allocation of transaction price would be:
|$100 per container * 1,000,000 containers||$100,000,000|
|$90 per container * 1,500,000 containers||$135,000,000|
|Total expected consideration||$235,000,000|
|Total volume of goods expected to be provided||2,500,000 containers|
|Transaction price allocated per container||$94 per container ($235,000,000 / 2,500,000)|
|Transaction price of first container allocated to material right||$6 ($100 – $94)|
Based on the allocation, the company would recognize revenue of $94 for the first container, with $6 (price paid by customer in excess of the transaction price allocated to a container) deferred as contract liability for the material right not yet satisfied. The contract liability accumulates until the discounted containers are delivered, at which time it will be recognized as revenue as the containers are delivered. Management should update its estimate of the total sales volume at each reporting date.