The Financial Accounting Standards Board ("FASB") and International Accounting Standards Board ("IASB") have been quite busy working on various projects and one area they are focusing their attention to standardize and converge on is revenue recognition, which can differ significantly between the two current standards. Current International Financial Reporting Standards ("IFRS") offer mostly principles based guidance on revenue recognition, while under U.S. GAAP there are separate sets of very specific revenue recognition rules that differ between industries such as construction and software.
On June 24, 2010, both the FASB and IASB released a proposed joint accounting standard on revenue recognition for public comment to take a step even closer to realizing the convergence of revenue recognition rules. The comment deadline is October 22, 2010. The proposal can be found on the FASB’s website and would affect any entity that enters into contracts to provide goods or services, unless those contracts are within the scope of other requirements of US GAAP or IFRS such as lease contracts, insurance contracts and guarantees.
Some of the key highlights of the proposal are discussed below.
The goal of the proposed standard is to develop a common revenue standard for U.S. GAAP and IFRS that would:
- remove inconsistencies and weaknesses in existing revenue recognition standards and practices;
- provide a more robust framework for addressing revenue recognition issues;
- improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets; and
- simplify the preparation of financial statements by reducing the number of requirements to which entities must refer.
The core principle of the proposal would require an entity to recognize revenue to record the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services.
The following five step process to revenue recognition is outlined in the proposal:
- Identify the contract(s) with a customer
There are certain specifications as to whether an entity would combine two or more contracts and treat them as a single contract or account, or segment a single contract into two or more contracts. Take, for example, a company that regularly sells two distinct products (for example, a medical device and a laptop computer) to the same customer in the same contract and did not offer a significant discount to the customer for buying the package. If the prices for the two distinct products were independent of each other, then the single contract would be segmented into two contracts. The contract can be written, oral or implied by the entity’s business practices.
- Identify the separate performance obligations in the contract
Under the new proposed guidance, "An entity shall evaluate the terms of the contract and its customary business practice to identify all promised goods or services and determine whether to account for each promised good or service." This can result in different separate units of accounting than under the current FASB revenue recognition rules. If a company sold a product, offered and sold extended warranties to its customers and other comparable extended warranties were offered by third parties, then both the delivery of the product and extended warranty would constitute separate performance obligations in the contract. Even if no third parties offered similar warranties, the extended warranty could still be considered a separate performance obligation, as long as it provides utility on its own and has a distinct profit margin.
For a regular warranty that is provided with each product that could present an obligation on the company’s part, there would be an initial deferral of revenue which would be recognized as warranty services are provided. Applicable warranty costs would be expensed as incurred.
- Determine the transaction price
The proposal highlights the use of a probability-weighted expected amount in determining the transaction prices. A company would estimate the amount of consideration to be received in exchange for transferring the goods or services. This may include contingent amounts and also take into effect the customer’s credit risk and the time value of money.
- Allocate the transaction price to the performance obligations
After determining the transaction prices, the company would then need to allocate the total amount of the consideration based on a relative standalone selling price basis only at the inception of the contract. In cases where stand alone value would be difficult to determine, the company can use a best estimate. This would have a more profound effect on companies that currently follow U.S. GAAP software revenue guidance, as vendor specific objective evidence (VSOE) would not necessarily need to be established to recognize revenue from the separate performance obligations.
- Recognize revenue when a performance obligation is satisfied
The proposal states that revenue should be recognized when a customer "obtains control of a good or service when the customer has the ability to direct the use of, and receive the benefit from, the good or service." This potentially could have a sizable impact on companies that use the percentage of completion method of revenue recognition, such as in most construction companies, who may determine that the customer obtains control of the good only after being constructed at the end of the project.
In light of these changes, it is expected that under the proposal, current revenue disclosures are likely to be expanded. The proposal has identified several disclosure requirements, including:
- Revenue disaggregated into "categories that best depict how the amount, timing and uncertainty of cash flows are affected by economic factors"
- Description of performance obligations in the company’s revenue contracts
- Significant judgments such as determining and allocating the transaction price to the performance obligations
- Information about performance obligations remaining at the end of the reporting period.
Leslie Seidman, FASB board member, has remarked that the proposed joint standard would "make accountant’s jobs easier when new types of business arrangements emerge because they’ll have one standard to look on how to recognize revenue for that arrangement." In conjunction with the IASB’s backing, it is likely that the revenue recognition steps highlighted in this article will become the new revenue recognition guidance and the final standard is expected to be released in the second quarter of 2011.