by Chris Murphy and Michael Gerlach
RSM US LLP is an IMA Member
Nonpublic business and professional services organizations—from law and engineering firms to consulting and advertising businesses—should currently be preparing for the Financial Accounting Standards Board’s new revenue recognition guidance in Topic 606, Revenue from Contracts with Customers, of the Accounting Standards Codification (ASC 606). With limited exceptions, the comprehensive new revenue recognition guidance is effective as of January 1, 2018 for public entities with a calendar year end and in the December 31, 2019 financial statements for nonpublic entities with a calendar year end. The following describes certain important accounting considerations under the new guidance. Business and professional services organizations should review these accounting considerations and the implementation considerations in our article, Revenue recognition: 5 key considerations for implementation, in preparation for successfully applying the new guidance.
Identify the Units of Account
Contracts with customers for business and professional services often include promises to provide multiple services. For example, the services provided by an executive recruiting firm may include interviewing candidates and performing background checks. In these situations, the service provider must identify the unit(s) of account. In other words, the service provider must determine whether: (a) all of the services it provides to a customer should be accounted for as one unit of account or (b) one or more of the services it provides to the customer should be accounted for separately. There are generally two steps an entity must perform when identifying the units of account in a customer contract:
- Identifying all of the promises to provide services
- Determining whether the promised goods or services that will be transferred should be accounted for separately
There are differences in how the units of account in a customer contract are identified under the new guidance compared to legacy U.S. generally accepted accounting principles (GAAP), which could lead to changes in the timing and amount of revenue recognized in a reporting period.
Account for Incentive Payments
Contracts with customers for business and professional services often include a component of variable consideration (e.g., an incentive payment). For example, the fees paid to a consulting firm may include an amount that is payable only if the consulting firm finishes providing the promised services by a particular date. In these situations, one of the criteria considered under certain legacy GAAP is whether the fee is fixed or determinable, which typically results in the recognition of most variable consideration when the related contingency is resolved. Under the new guidance, an estimate of the amount of variable consideration that the entity expects to be entitled to is included in the transaction price subject to a constraint that limits the variable consideration to the amount for which it is probable that a significant reversal in cumulative revenue recognized will not occur. Even with this constraint, earlier recognition of variable consideration is still expected to occur in many cases under the new guidance.
Determine Whether Revenue Should be Recognized Over Time or at a Point in Time
The new guidance provides a comprehensive model that addresses the accounting for the sale of both goods and services across virtually all industries. Under the new guidance, a determination must be made regarding whether a performance obligation is satisfied at a point in time (in which case revenue is recognized at the point in time that control of the underlying goods or services is transferred to the customer) or over time (in which case revenue is recognized over time as control of the underlying goods or services is transferred to the customer). At least one of the following criteria must be met to conclude that a performance obligation is satisfied over time:
- The customer simultaneously receives and consumes benefits as the entity performs.
- Control of the promised goods or services transfers to the customer as the entity performs.
- The asset created by the entity’s performance does not have an alternative use to the entity and the entity’s right to payment for its performance to date is enforceable.
If none of the criteria are met, revenue is recognized at a point in time.
Because there is limited guidance in legacy GAAP about how a service provider should account for customer contracts that do not fall within the scope of legacy GAAP’s industry-specific guidance, it is possible that there could be significant differences with respect to when revenue is recognized for these contracts under legacy GAAP and the new guidance.
Recognize Revenue as a Principal or an Agent
When another party (e.g., subcontractor, third-party service provider) is involved in providing services to the service provider’s customers, the service provider must determine whether it should be recognizing revenue as a principal (i.e., gross) or an agent (i.e., net). Examples of services for which it is not uncommon for more than one party to be involved in providing the service to the customer include internet advertising, maintenance or cleaning services, and travel and ticket agency services. The approaches used in legacy GAAP and the new guidance to determine whether an entity should be recognizing revenue as a principal or an agent are fundamentally different. Legacy GAAP focuses solely on an analysis of several indicators to determine whether the entity is acting as a principal or an agent. While the new guidance incorporates consideration of three indicators, its overall focus is on whether the entity controls the specified good or service before it is transferred to a customer. If so, it is a principal and reports revenue gross. If not, it is an agent and reports revenue net. Given the fundamental change in determining whether revenue should be recognized as a principal or an agent, it is possible that applying the new guidance could result in an accounting outcome different from that which resulted from applying legacy GAAP.
Account for Contract Modifications
Certain service providers commonly enter into multiyear contracts with customers. It is not uncommon for many of these contracts to be modified at some point over their duration. For example, a five-year contract for transaction processing services may be modified by the service provider and its customer to incorporate an additional transaction stream that the customer wants the service provider to process. Under legacy GAAP, there is very little guidance about how to account for contract modifications. Conversely, a comprehensive model is provided in the new guidance related to accounting for contract modifications. This model depends on a number of factors, including the pricing of the modification, whether any new goods or services added by the modification are distinct and whether any of the remaining goods or services are part of a partially satisfied single performance obligation. Following the new guidance could result in accounting for a contract modification as any of the following depending on the facts and circumstances: (a) a separate contract, (b) the termination of one contract and execution of a new contract (which results in prospective treatment), or (c) part of the original contract (which could result in recognition of a cumulative catch-up adjustment). Given the lack of guidance in legacy GAAP and the introduction of a comprehensive model under the new guidance, the potential exists for the new guidance to affect the timing and amount of revenue recognized in a reporting period for modified contracts.
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