The Financial Accounting Standards Board’s (FASB’s) new revenue recognition standards, more formally known as the Accounting Standards Update (ASU) Revenue from Contracts with Customers, will affect not just public companies, but also the many private companies whose lenders or investors require them to follow Generally Accepted Accounting Principles (GAAP). If your organization is one of them and has a calendar year end, the standards become effective starting in 2019.
What’s behind the new standards? A primary goal was to shift away from the previous rules-based approach to revenue recognition, which varied by industry, and toward a principles-based approach, which applies more broadly. To that end, the new standards apply to most customer contracts across numerous sectors, including high tech, retailing and manufacturing. Several specific types of transactions, such as lease and insurance contracts and some financial instruments, are excluded.
A fundamental principle behind the standards is that organizations should recognize revenue “to depict the transfer of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services,” according to the FASB. It has outlined a five-step process for applying this principle:
- Ensure parties can identify the payment terms. Several criteria must be met for a contract to exist. Among others, the parties must have approved the contract, and they must be able to identify the payment terms.
- Ensure parties can identify the performance obligation(s) in the contract. A performance obligation is a promise to deliver a good or service to the customer.
- Determine the transaction price. This should account for, among other factors, variable consideration, a significant financing component or a noncash component.
- Allocate the transaction price to the performance obligations in the contract. If the contract includes more than one performance obligation, the transaction price should be based on the relative stand-alone price of each good or service.
- Recognize revenue when (or as) the organization satisfies the performance obligation by transferring the promised goods or services to the customer. When an organization satisfies the performance obligation over time, it can measure its progress in one of two ways. The input method recognizes revenue based on inputs used, such as labor or machine hours. The output method recognizes revenue by measuring the value to the customer of the goods or services transferred. This could be handled, for instance, by identifying the milestones reached.
If you use GAAP, the new revenue recognition standards likely will affect your organization’s financial statements, tax obligations and loan agreements. They also may require changes to your firm’s accounting processes and IT systems. Your accounting professional can help you identify the changes needed and offer guidance on implementing them.
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