The Financial Accounting Standards Board’s (FASB) update to revenue recognition is going to impact nearly everyone across all industries. But what are these new standards and why won’t your accountant stop talking about it? When it comes to the new revenue recognition standards, here’s the gist of it: Accounting Standards Update 606 (ASU 606) deals specifically with recognizing revenue from customers with contracts. If you are sighing in relief because this does not apply to you, think again. ASU 606 states that contracts can be written, oral, or even implied. At its core, ASU 606 attempts to more accurately align the recognition of revenue with the completion of the contract, or even more accurately, the completion of performance obligations within the contract.
Now that we have an understanding of the scope and objective of ASU 606, let’s talk about how to implement it and what kind of financial reporting requirements you need to know. The FASB has provided a five step process for recognizing revenue from contracts with customers:
Step 1 – Identify the Contract.
In previous standards this was pretty straight forward. With ASU 606, one of the biggest changes is the requirement to combine multiple contracts into one for the purpose of financial reporting. This is required if the contracts have the same commercial objective, are interdependent, or share a single performance obligation.
Step 2 – Identify Performance Obligations.
Once all contracts have been identified, and if necessary, combined, we are now required to identify each distinct or “bundled” performance obligations within each contract. These performance obligations will now be our benchmarks for when and how we recognize revenue.
Step 3 – Determine the Transaction Price.
Gone are the days when the stated price of the contract is the determining factor for actual value of the contract. Instead, we must now determine the transaction price of the contract by estimating the consideration we expect to be entitled to upon completion of the contract.
Step 4 – Allocate the Transaction Price.
We suspect that of the five steps in ASU 606, this will be the one that most people get hung up on. There are three methods available for use when allocating the transaction price among it’s performance obligations. These methods are the adjusted market approach, the expected cost plus margin approach, and the residual approach. Each method requires an in depth discussion to truly understand proper application, but for brevities sake, identification of these methods will have to do.
Step 5 – Recognize Revenue.
It is finally time to recognize revenue! Revenue is recognized as performance obligations are satisfied. The key point to remember about this step is that revenue should be recognized either over time, or at a point in time, and that these two approaches are mutually exclusive from each other.
If you are still wondering what all of this means for you and your business, don’t go it alone! Contact your accountant to help guide you through.
By Melissa Liu and David Hegstrom, Harris CPAs
As a seasoned financial expert with a comprehensive understanding of accounting standards, including the latest updates, I can attest to the profound impact that the Financial Accounting Standards Board’s (FASB) update to revenue recognition, specifically Accounting Standards Update 606 (ASU 606), will have across diverse industries. My depth of knowledge in this area allows me to shed light on the intricate details of ASU 606 and its implications for businesses.
Firstly, it's crucial to recognize that ASU 606 focuses on the recognition of revenue from customers with contracts. Contrary to previous standards, ASU 606 broadens the definition of contracts to include not only written agreements but also oral and implied contracts. This expanded scope ensures that a wide range of business arrangements falls under the purview of the new standards.
At its core, ASU 606 seeks to align revenue recognition more accurately with the completion of contractual obligations. This extends to the completion of performance obligations within the contract, emphasizing a more nuanced and precise approach to revenue recognition.
The five-step process outlined by the FASB for recognizing revenue from contracts with customers is a cornerstone of ASU 606 implementation:
1. Identify the Contract: In this step, the significant departure from previous standards is evident. ASU 606 requires the combination of multiple contracts into one for financial reporting purposes, provided they share the same commercial objective, are interdependent, or share a single performance obligation.
2. Identify Performance Obligations: Following the identification of contracts, the next step involves pinpointing distinct or "bundled" performance obligations within each contract. These performance obligations become benchmarks for the subsequent recognition of revenue.
3. Determine the Transaction Price: Unlike earlier practices where the stated price was the determining factor, ASU 606 mandates the estimation of the transaction price based on the consideration expected upon completion of the contract.
4. Allocate the Transaction Price: This step introduces potential complexity, as businesses are required to choose among three methods for allocating the transaction price: the adjusted market approach, the expected cost plus margin approach, and the residual approach.
5. Recognize Revenue: The final step involves recognizing revenue as performance obligations are satisfied. It's crucial to note that revenue recognition can occur either over time or at a specific point in time, and these approaches are mutually exclusive.
Understanding the implications of these changes and effectively implementing ASU 606 requires a nuanced grasp of financial reporting requirements. Given the intricacies involved, businesses are encouraged to seek guidance from their accountants to navigate the challenges posed by this significant update.
In summary, the introduction of ASU 606 marks a paradigm shift in revenue recognition, emphasizing a more comprehensive and nuanced approach that necessitates a thorough understanding of its intricacies for successful implementation.
