IMGCAP(1)]The Financial Accounting Standards Board recently issued an exposure draft on revenue recognition that is expected to have a significant impact on accountants, auditors and entities alike.
The comment period for the draft ends Oct. 22, 2010, and the Accounting Standards Update is expected to become part of FASBs official Accounting Standards Codification during the second quarter of 2011.
The International Accounting Standards Board has also issued an exposure draft on revenue recognition with comments due on the same date. Both boards are accelerating the pace of standard-setting given their joint goal of converging global accounting standards. Their individual EDs are substantially similar.
All parties must plan now for the changes that these standards will require. Time-tested revenue recognition standards that many businesses use will change dramatically. Many manufacturers, distributors and resellers of goods and services will be affected.
Key accounting principles related to revenue recognition are scheduled to be either eliminated or modified. These principles include, but are not limited to, the following concepts: when goods are shipped, when a customer pays cash or credit for goods, when a service is delivered, when costs are matched with revenue, when warranty reserves are accrued, and when the title for goods is passed to a customer.
Under the proposed standards, auditors will no longer be able to test revenue recognition by simply verifying that cut-off dates are correct by examining bills of lading, cash register receipts or signed customer receipts for services rendered. A new set of accounting procedures, systems, and internal controls will be required to record, control and audit an entity's revenue.
Risk and Rewards
The proposed ASU applies many new concepts for revenue recognition. Such concepts include, but are not limited to, the following principles: the transfer of risks and rewards of ownership, passage of "control" to the customer, and single and multiple "performance obligations as the drivers of revenue recognition. The current transfer of title criteria for revenue recognition will now become only a part of the overall revenue recognition criteria.
Under the ED, a core principle is that an entity recognizes revenue when goods or services are transferred to customers in the amount of the contract price that the entity expects to receive in exchange for those goods or services. An entity will be required to evaluate contract terms and customary business practice to identify all goods or services to be delivered under the contract.
The entity must also determine if separate performance obligations exist for each of the contract's identifiable goods or services to be delivered. For contracts with multiple performance obligations, an entity will be required to disaggregate the separately identifiable performance obligations on a relative selling price basis to determine the amount of revenue to be recognized. It will need to use several types of information to develop relative selling prices, including vendor-specific objective evidence, third-party objective evidence, and/or internally developed estimates as a basis if other information is unavailable.
Each relative selling price will be used to allocate an entity's contract price to identifiable performance obligations for recognition of revenue. The proposed ASU eliminates use of the residual allocation method for recognition of revenue under multi-faceted performance obligation contracts.
Under the proposed ASU, an entity would recognize revenue only when it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred to a customer when the customer obtains control of that good or service.
Furthermore, a customer obtains "control" of a good or service when the customer has the ability to direct the use of, and receive the risks and rewards of ownership from, the good or service. "Control" is also identified as the capability to stop other entities from directing the use of, and receiving the risks and rewards from, a good or service. An entity shall assess the transfer of control of goods or services for each separate performance obligation.
Measurement of Revenue
Under the proposed ASU, as an entity completes and satisfies a performance obligation, the entity will recognize revenue in the amount of the contract price allocated to each individual performance obligation.
An entity would need to consider the terms of the contract and its normal and customary business practices in the determination of the transaction price to be recognized in revenues from the contract with the customer.
Normally, the transaction price reflects the amount of consideration that an entity expects to receive from the customer in exchange for transferring goods or services. Under the proposed ASU, in some instances credit risk, time value of money, non-cash consideration, right of return, probable warranty claims, or monies payable to the customer may affect the valuation of the transaction price to be recognized as revenue.
An entity shall recognize revenue from satisfying a performance obligation only if the transaction price can be reasonably estimated.
Increased Disclosure
To help users of financial statements understand the amount, timing and uncertainty of revenue and cash flows arising from contracts with customers, an entity would need to disclose qualitative and quantitative information about the entity's contracts with customers; and the entity's material judgments and changes in judgments made to apply the guidance to those contracts.
The new revenue recognition standards are bound to have a substantial impact upon the business entities of America and the accounting profession. Time is of the essence to plan, develop and implement business systems, internal controls, and financial reporting methodologies and procedures to account for revenue under this proposed accounting standards update.
Philip Andrew Codelka is a CPA with bachelors and masters degrees in accounting from Duquesne University. He is affiliated with Lehan Partners LLC, an Atlanta-based consulting firm.
