The ASC 606 transition: A revenue recognition primer

In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued the long awaited converged standards on revenue recognition, Accounting Standards Update 2014-09 (Topic 606), Revenue from Contracts with Customers (affecting Accounting Standards Codification (ASC) 606) and International Financial Reporting Standards (IFRS) 15. The issuance culminated a lengthy due process by the boards, consisting of extensive outreach to users and preparers of financial statements. During the course of the due process, the original draft was changed significantly in response to the comments of various stakeholders.

The objective of the project was to create a unified, principle-based standard on accounting for revenue from customers. In doing so, the FASB replaced hundreds of pages of rules-based guidance designed for specific industries, like construction or software, while the IASB provided the first comprehensive revenue recognition guidance contained in IFRS. This is a significant and important event, as the standard affects virtually every entity that prepares financial statements in accordance with GAAP or IFRS. Moreover, the standard impacts what is arguably the most important number in financial statements: revenue.

With this article, Baker Tilly is beginning a series designed to provide you with a general overview of the requirements of the standards and insight into the challenges of transitioning to the new standard. Although the impact on the revenue recognized will vary across a wide spectrum for different organizations and industries, for all there will be a need for significant changes in the process of how revenue is recognized and a need for changes and modifications to internal controls, IT systems, contracts, and other business processes. Depending on the financial statement impact, there could be effects on compensation arrangements, loan agreements, etc. as well.

Transition preparation timeline

If you have not begun to address this transition in your organization, the time to act is now. After a deferred effective date was issued by the boards, the standard is now effective for:

  1. Fiscal years beginning after December 15, 2017: for public companies and certain not for profit entities that have issued conduit debt obligations
  2. Fiscal years beginning after December 15, 2018: for all other entities

For issuers that are accelerated filers, this means the revenue being recognized during this year, 2016, may need to be restated as part of the transition in 2018.

The elements of revenue recognition

Briefly stated, ASC 606 now provides a structure through which all revenue transactions must be assessed. It consists of five elements, as follows:

  1. Identify the contract with a customer
  2. Identify the performance obligations (promises) in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations
  5. Recognize the revenue when (or as) the reporting organization satisfies the performance obligations

We will cover each of the five elements in depth in upcoming articles. Each element contains new concepts which will need to be assessed as to the impact in a particular organization. To do so will require more judgments and estimates than has been necessary under previous revenue guidance. In addition, we will discuss the disclosure requirements, transition methods, and cost accounting issues.

Definitions

With the issuance of the new revenue recognition standards, the FASB updated its glossary with several new definitions. They include:

Contract

An agreement between two or more parties that creates enforceable rights and obligations.

Contract asset

An entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).

Contract liability

An entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or the amount is due) from the customer.

Customer

A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.

Performance obligation

A promise in a contract with a customer to transfer to the customer either:

  • A good or service (or a bundle of goods or services) that is distinct; or
  • A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer

Probable (second definition)

The future event or events are likely to occur.

Revenue

Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Standalone selling price

The price at which an entity would sell a promised good or service separately to a customer.

Transaction price

The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties.

Scope

As noted above, there are no scope outs for specific types of entities, which is often the case with accounting standards. There are however, certain types of transactions which have been scoped out. These are:

  • Lease contracts
  • Insurance contracts
  • Financial instruments
  • Guarantees
  • Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers

For more information on revenue recognition, or to learn how Baker Tilly’s specialists can help, contact our team.

© 2024 Baker Tilly US, LLP

Leases: New financial reporting rules for business leases
Next up

Leases: New financial reporting rules for business leases