August 28, 2014 The following article, which has been slightly modified for publication here, about revenue from contracts was first published in August, 2014. The article is included here as a representative sample of the expertise of KatzAbosch’s professionals in the subject matter covered by the article. The article has not been updated to take into account subsequent developments, if any. Accordingly, the article is not intended to be a description of the current state of affairs in this area or to provide advice to viewers. The article should not be relied upon in making any financial, legal, accounting, operational or other decision. After several years of deliberation, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09 (ASU 2014-09), which will result in substantial changes in revenue recognition under U.S. GAAP. As expected, ASU 2014-09 sets forth an entirely new revenue recognition model, codified in FASB ASC 606-10, requiring the following steps: 1. Identifying the contract (including whether contracts should be combined) 2. Identifying the performance obligations 3. Determining the transaction price (including assessment of the impact of variable consideration) 4. Allocating the transaction price to performance obligations 5. Recognizing revenue upon satisfaction of performance obligations Contracts Under the provisions of ASU 2014-09, a contract is an arrangement, whether in writing or not, that creates enforceable rights and obligations between the parties. Because of this broad definition, the standard is expected to apply to the vast majority of arrangements with customers. Performance Obligations ASU 2014-09 indicates that the transaction price should be allocated to each distinct performance obligation in an arrangement. In addition to specifying a variety of other indicators of a distinct performance obligation, the standard states that a performance obligation is distinct if the customer can benefit from the good or service on its own or with resources readily available to it and the promise to transfer the good or service is separately identifiable from other promises in the contract. Transaction Price Under the ASU 2014-09, entities are also required to determine the transaction price under the arrangement, which represents the amount to which the entity expects to be entitled as a result of the satisfaction of the performance obligations, excluding amounts collected on behalf of third parties. Determining the price requires assessment of variable consideration (e.g. rebates, penalties, etc.) and calculating the time value of money if the period from the satisfaction of the performance obligation through the date of expected payment exceeds one year. Additionally, the standard requires entities to record non-cash consideration received from customers at fair value or, if fair value is not available, at the standalone selling price of the goods or services delivered. Finally, entities will also have to determine whether cash consideration is payable to the customer or if the customer is granted the right to apply amounts against consideration payable to the entity. If so, such amounts should be recorded like any other purchase or as a reduction in revenue (or, in some cases both). Allocating the Transaction Price Under ASU 2014-09, the transaction price should generally be allocated to each performance obligation based on the relative standalone selling price. If the relative standalone selling price can not be determined, then an entity may estimate the price based on an assessment of its market (i.e. the price charged by competitors adjusted for the reporting entity’s costs and margins or based on the reporting entity’s estimate of what the customer would be willing to pay) or based on a cost plus margin approach. If the price of one or more performance obligations is highly variable or uncertain, then entities have the option of using the residual method under which they would allocate the price to other performance obligations and then allocate the remainder to those with highly variable or uncertain selling prices. Discounts are also allocated based on the relative standalone selling price unless an entity regularly sells each performance obligation separately and there is clear evidence that the discount relates to specific performance obligations. In the event that there are price changes, the changes should be allocated in the same manner as the original transaction price unless the change relates to specific performance obligations and the amount allocated to a specific performance obligation reflects the amount to which the reporting entity expects to be entitled as a result of the satisfaction of the performance obligation. If a price change is allocated to a satisfied performance obligation, then revenue should be adjusted in the period of the price change. Satisfaction of Performance Obligations Under the new revenue model, entities will have to determine whether a performance obligation is satisfied over time or as of a point in time, which could be particularly challenging for service entities. To be considered satisfied over time, the reporting entity’s performance either creates or enhances an asset that the customer controls as the asset is created or enhanced. Performance is also satisfied over time for a pure service contract that the entity expects to fulfill if: 1. the performance does not result in the creation of an asset with an alternative use and the entity has a right to payment for performance completed to date; 2. the customer simultaneously receives and consumes the benefits of the entity’s performance (as the entity performs the services); and 3. another entity would not need to substantially re-perform the work completed to date if it were to fulfill the remaining obligation to the customer. If an obligation is considered satisfied over time, then revenue should be recognized over time if an entity can reasonably estimate progress. The amount recognized in any period should be calculated using either input or output methods, as long as the method used depicts progress towards satisfaction of the performance obligation. The standard indicates that goods or services that do not contribute toward the satisfaction of the performance obligation should not be included in measurement. If any entity cannot reasonably estimate progress, but does not expect to incur a loss, then it is permitted to recognize revenue equal to costs incurred. For performance obligations satisfied at a point in time, an entity should recognize revenue when it transfers control of the resulting asset to the customer. Control is considered transferred when the customer has the right to direct the use of the asset as well as the right to obtain substantially all of the remaining benefits from the asset. When determining whether transfer has occurred, an entity must consider the customer’s ability to use, hold, sell, exchange or pledge the asset. Additionally, the entity must carefully consider repurchase rights or obligations because some may result in lease or financing accounting. Effective Dates ASU 2014-09 is effective for public companies for annual periods beginning after December 15, 2016 and interim periods within those annual periods. Early adoption is not permitted. It is effective for nonpublic companies for annual periods beginning after December 15, 2017 and interim periods within annual periods beginning after December 15, 2018. Nonpublic entities are permitted to adopt the provisions for annual periods beginning after December 15, 2016 and interim periods within those annual periods, annual reporting periods beginning after December 15, 2016 and interim periods within annual periods beginning after December 15, 2017, or annual reporting periods beginning after December 15, 2017 and interim periods within that reporting period. ASU 2014-09 provides alternative methods of initial adoption. Option #1: Retrospectively to each prior reporting period presented. When electing this option, an entity can also use any of the following practical expedients: First, for contracts completed before the date of initial application, an entity does not need to restate contracts that begin and end in the same annual reporting period. Next, for contracts with variable consideration that were completed before the date of initial application, entities are permitted to use the transaction price at the date the contract was completed rather than estimating variable consideration amounts in the comparative reporting periods. Finally, for all periods presented before the date of initial application, entities do not need to disclose 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. Option #2: Retrospectively with the cumulative effect of initially applying the update recognized at the date of initial application with disclosure of the amount by which each financial statement line item is affected in the current year as a result of the entity applying the new revenue standard as well as an explanation of the significant changes between the reported results under the new revenue standard and prior US GAAP. For a complete copy of ASU 2014-09, follow this link. For more information on the revenue recognition standards, please contact Claudia Wolter at cwolter@www.katzabosch.com or 410.307.6438.
