In this summary, we will cover:
- How the new revenue recognition affects businesses in different industries.
- The disclosures required under the new guidelines.
- The core principles of the new revenue recognition standard.
- The industries that will have most impact from the new guidelines.
- Under the old regulation, there were numerous ways of recognizing revenue depending on the industry and specific transactions. This led to usage of different accounting methods and standards for the same transactions.
- Under the new guidelines, revenue will be recognized using consistent principles regardless of the industry or region of businesses.
- The new guideline requires companies to disclose a number of details that show users of the financial statement the company’s contracts with its customers. This will be an improvement on the earlier guideline where most companies gave little information regarding revenue contracts.
- The new guideline is effective from December 15, 2017 for public companies. They are, however, allowed to apply the new guideline early.
- For Not-for-profit organizations and private companies, the new reporting standard will be effective from December 15, 2018 and early implementation is allowed.
- The new guidelines will affect a number of industries but the aerospace, software, construction, real estate and telecommunication industries will be the most affected.
As much as revenue is one of the key factors considered by investors when making investment decision, revenue disclosures by companies and regulations by various regulation bodies have been industry specific and limiting. IFRS, for example, has two standards for recognizing revenue. Both standards are believed to be difficult to apply and even understand. This could explain why the two standards have limited implementation. GAAP, on the other hand, has revenue recognition standards that are detailed, complex and disparate. All the standards vary in terms of application because application is different for each industry as well as transaction.
In order to control this, the FASB and IASB came together in early 2014 to come up with better regulation standards for recognizing revenue generated by a company from contracts they have with their customers. The new guidelines for revenue recognition removes the industry and transaction specific regulations that were there before. It also has a number of disclosures that were not made initially. All what this does is keep the consistency of revenue recognition across all industries as well as giving investors better and more detailed information about revenue to help them make their decisions.
The new revenue recognition has five core principles:
- First, as a company, you need to determine whether there is any contract in existence between you and the customer. A contract needs to be written or oral for it to be considered viable under the new standards.
Additionally, the rights of each party in the contract need to be stipulated as well as the payment terms.
- Secondly, the performance obligations of each party have to be identified.
- The third core principle is determination of the transaction price. While determining this, variable considerations need to be in place. Items such as discount, refunds rebates, future forecasts as well as historical data need to be considered when estimating the price of the transaction. Any constraining events both internal and external that could affect the consideration that will be received should be considered. Payment time should also be considered because of time value of money, which should be accounted for.
While still on the third principle, in cases where payment is noncash, the price of the goods or services should be estimated at a fair value of what the buyer receives. Finally, if there is anything else owed to the customer outside of the goods or service delivered, the revenue recognized should be less this amount.
- The fourth principle touches on allocation of the price to match the performance of the signed contract.
- The final principle is recognition of revenue when (or as) performance obligations as stipulated in the contract are satisfied.
ASC 606, the revenue recognition update from the FASB, affects every business dealing with contracts in some way. Industries that are affected the most by the new standards are real estate, asset management, aerospace, telecommunication, construction and software.
The new standard also has new requirement for disclosures on the financial statements.
- One of the disclosures is disintegration of revenue recognized from the company’s customers into the appropriate categories.
- The balances of any categories should also be disclosed. This includes opening and closing balance of contract assets, liabilities and receivables.
- The third item that needs to be disclosed is the performance obligation.
- The final item on disclosures is any significant judgements as well as changes in judgement that are made when applying the requirements to the contracts.
The changes will be effective from December 15, 2017 for public companies for both annual and interim reports. For private companies and not-for profit organizations, the implementation will be effective for annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019.