Revenue is one of the key elements provided by financial statements and the one most carefully scrutinized. Companies use revenue data to track and measure their success, and it is used by people outside of the company, such as investors and lenders, to determine the potential future health of the organization. Since this is such an important metric, the Financial Accounting Standards Board (FASB) has endeavored to develop a method of revenue recognition that is standardized for all types of companies to facilitate “apples to apples” comparisons. This method focuses on contracts with their customers that deliver goods and services over a given period. Before this new guidance, the U.S.generally accepted accounting principles (GAAP) sometimes differed from the international financial reporting standards (IFRS). The new code reconciles the two and creates a standardized method of calculating revenue.
Types of Revenue
Companies that use cash-basis accounting simply record revenue when they receive payments. In contrast, the accrual method tries to match income and the costs associated with generating that income into the same accounting period. The amount and timing of revenue streams are relatively straightforward for most companies, but for some, it gets a bit more complicated. The implementation of the Financial Accounting Standards Board (FASB) topic ASC 606 addresses the revenue recognition rules for these contracts.
In retail companies that sell goods for a given price, revenue is easy to identify, but in others, the timing of revenue recognition is less straightforward. For example, professional services firms may recognize revenue on a percent complete basis or upon certain milestones of completion. In those cases, it can be more challenging to determine the correct timing and amount of revenue to apply to a given period. And, in a global economy, the answer must be the same, whether inside the U.S. or out.
Overview of New Guidance
The FASB issued this new guidance related to contracts with customers to standardize financial reporting across industries as well as borders. It applies primarily to professional service firms and software companies with annual or monthly contracts. The principles defined in the new code provide information about how a business should deal with questions of timing and the certainty of collection. The new system tries to match revenue in appropriate proportion to the services provided, and clarify how to allocate that revenue throughout the term of the contract. It may often require the disaggregation of bundled products to consider each component separately. The new guidance helps determine when revenue can be recognized, and how much of it, using the transfer of control between parties as a determining factor.
The transition process can be challenging, simply because of the granular level of detail involved. It may be hard to decide where to start. But according to guidance by the FASB, it’s best to begin by assessing the types of contracts your business uses and grouping them by category. The full-retrospective method of transitioning open contracts involves restating the revenue for all prior accounting periods. The modified-retrospective transition method would restate only the latest accounting period, leaving the historical periods in line with the legacy GAAP rules
As anyone who has completed the transition will probably tell you, the process can be a lot of work. Fortunately, the FASB has provided a roadmap to follow. By using the five-step approach identified in the guidance, you can determine when and how much revenue to recognize:
Identify the contract with the customer
Identify the performance obligation
Determine the transaction price
Allocate the transaction price to the performance obligation
Recognize revenue when (or as) the entity satisfies the performance obligation
Timing of Implementation
Initially, the deadline to implement this new methodology was December 2019, and many companies have already made the transition. However, due to the disruptions caused by COVID-19, the deadline has been deferred. The new date differs depending upon whether an entity is public or private, though most public companies and many private ones have already completed the implementation.
The topic of revenue is one that is near and dear to the hearts of business owners. Revenue data is critical for internal decision-making. It is also crucial for those making determinations about the health of the organization, such as lenders and investors. In a global economy, it is also essential that both domestic and international revenue calculations are following the same guidelines and result in the same numbers. The new code focuses on contracts with customers, where delivery of services occurs over time. For software companies, it may require the unbundling of some products. The transition process may be difficult and time-consuming, but the FASB has done a great job of mapping out and documenting the steps to follow.