Accounting Standards Update 2014-09 Revenue from Contracts with Customers - Research Paper Example

Accounting Standards Up 09 Revenue from Contracts with s of The introduction of topic 606 under accounting standards update 2014-09 in the US GAAP by FASB and IASB has been a significant move in terms of development in the revenue recognition standard. The paper discusses the current US GAAP principle of revenue recognition along with that in ASU for understanding the implications of the same on general reporting, especially on multiple element arrangement. For gaining clear insight of ASU 2014-09, the paper has also discussed the five step model and portfolio approach regarding revenue recognition. Introduction In May 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) agreed upon modifying the existing standard of revenue recognition (Accounting Standards codification 605) in Generally Accepted Accounting Principles (GAAP) and publish Accounting standards update 2014-09 (AICPA, 2014). The paper aims at understanding the implications of the update in context of revenue recognition in a broad manner. Alongside, it will also highlight impact of the new development in terms of improvement in financial reporting. Revenue recognition principle in the present GAAP Revenue is a very crucial element of the financial statement as it helps investors and other interested parties of an organisation in assessing the financial performance as well as position of the company with respect to others in an industry. It was observed that significant differences existed between revenue recognition principle of US GAAP and that of International Financial Reporting Standards (IFRS). It was also ascertained that both the standards required certain improvements so as to improve the overall quality of financial reporting (Gallistel, et al., 2012). The previous revenue recognition guidelines in the US GAAP integrated broad concepts with various revenue requirements that were industry-specific; this process complicated the overall system of reporting. Contrastingly, IFRS revealed very limited information which made it difficult to account for complex transactions. The new revenue recognition guidance replaces transaction specific and industry specific revenue recognition measures with a principle based approach which is more specific in nature (Ernst & Young, 2014; PWC, 2014a). The boards, FASB and IASB, responded to the above mentioned challenges by developing a converged set of requirements that meet existing issues in US GAAP and IFRS. The guiding principle of the new standard aims at ensuring that companies recognise revenue for depicting transfer of goods and services to consumers in an amount which reflect the relevant consideration (payment) that the company is entitled in exchange of respective goods and services. In this context, the chairman of FASB added that the issuance of the converged standard is just the first step and not the end of the complete process. The new standard will further ensure that revenue disclosures are more enhanced in terms of clarity and transparency, transaction related to contract modifications and service revenue are addressed in a comprehensive manner and guidance related to multiple element arrangements (ASC 605-25) are improved (FASB, 2014a; 2014b). The guideline regarding multiple element arrangements is applicable on various schedules that require vendors to provide more than a product or service (elements and deliverables) which are not considered within the purview of other accounting standards. For applying the standard, the arrangements are denoted as contractually binding agreements irrespective of it being written or orally implied. The guidance also account for circumstances when a single arrangement comprises multiple agreements with a common counterparty. ASC 605-25 provides separability of deliveries in context of different accounting units in a particular arrangement and allocation of consideration to respective units. The following measures should be complied for a deliverable to be considered as a separate unit of accounting: On a standalone basis, the delivered item (s) should be valuable to the consumer. When general right of return exists with respect to delivered item, delivery of undelivered product(s) is considered probable and under substantial control of the vendor. The Standard, ASC 605-25 does not incorporate guidance regarding when consideration of an arrangement is to be considered as revenue. Instead, the guideline only addresses the determination of revenue when more than single unit of accounting exist in context of multiple element arrangement and measurement and allocation of consideration related to an arrangement when multiple units of accounting subsist. Additionally, the standard does not direct revenue recognition when individual unit of accounting exists. The multiple-element arrangement guideline can have certain impact on the number of separate accounting units recognised; even so, companies need to implement the same for the identified units when services and products are delivered. Under a number of circumstances, the ASC 605-25 guidance has significant impact on point (time) of revenue recognition when separation criteria are not met. Under such situations, deliverables contained in a multiple-element arrangement are accounted as a single accounting unit (Ernst & Young, 2014; FASB, 2009). Detailed overview of the core principle of revenue recognition The revenue standard defines principles which an entity can apply for reporting necessary information regarding amount, time and uncertainty related to revenue and cash flow associated with a contract of delivering goods and services to consumers. The core principle suggests that an entity needs to recognise its revenue for portraying transfer of goods and services to consumers for an amount that reflects consideration (payment) earned in exchange of the delivery. The revenue standard is applicable to all contracts that involve consumers. However, there are certain exceptions; for instance, when a contract is accounted within scope of another standard such as lease, financial instrument and insurance then principle of revenue recognition is not applicable. Changes in context of biological asset valuations and investment property valuation under IFRS are not considered under revenue recognition standard. Alongside, a number of arrangements exist where scope of other standards coexist with that of the revenue standard. In such situations, the elements are segregated from each other and are accounted under respective standards (FASB, 2014c). FASB and IASB have developed a five step model that companies will be using for recognising revenue from various consumer oriented contracts. The model has been discussed in the following section but a brief overview suggests that there are certain criteria that should be met for considering a contract to be accounted using this model. Any entity should assess the likelihood of it being able to collect the claimed or entitled amount before applying the guidance related to the revenue standard. A contract is defined by a promise where an organisation or individual promises to transfer goods or services to its consumers. A performance obligation is also considered as a promise according to the revenue standard. The performance obligation can be either straight forward or complex depending upon the contract agreement. Therefore, entities should pre-decide if the performance obligation is to be accounted separately or as group. The transaction price is the value of consideration that an entity is entitled to once the goods or services are delivered to the consumer. Factors such as variable consideration, discount allocation and non-cash consideration play an important role in determining the transaction price. The revenue recognition standard comprises a number of measures for determining selling price when transactions are comparatively complicated. Revenue is generally recognised as the performance obligations are completed. Guidance is provided under the revenue standard so as to determine whether an obligation is performed within time or over time and the revenue is recognised accordingly (FASB, 2014c). Besides five step framework, portfolio approach is also implemented by a number of entities. A portfolio approach to revenue recognition is useful when a group of contracts or performance obligations are considered instead of a single one. An entity must make assumptions and make an estimate of the size and composition of the portfolio while applying this approach. Portfolio approach is considered effective when an entity enters into contracts with large number of consumers having similar terms and conditions. However, this approach may not prove fruitful when implemented in context of performance obligation related to non-similar products (FASB, 2014c; PWC, 2014a). Five step model The provisions under the five step model are: 1. Identification of the contract with a customer 2. Identification of performance obligation in the contract 3. Determination of transaction cost 4. Allocation of transaction cost to performance obligation 5. Revenue recognition as performance obligation is satisfied by the entity Step 1: Identify the contract with a customer A contract is defined as any agreement (written, verbal or implied) between two or more parties bounded by obligations that enforceable by the law. There are certain criteria which should be met before an entity considers it within the purview of a contract: Commitment and approval of both the parties Well-defined rights for both parties Clear instruction regarding payment terms The contract should have a commercial substance The entity must collect the entitled consideration only after exchange or transfer of goods or services to the consumer Guidance has been provided in the revenue standard regarding contract modification as an entity may need to combine two or more contracts and account for them as one (Marshall, 2014; PWC, 2014b). Step 2: Identification o performance obligation in the contract It has already been discussed in the paper that the promise in a contract is reflected by performance obligation where an entity is responsible for transferring goods and services to the consumer. When the promise obligates the entity to transfer more than one kind of goods or services to the consumer, the entity must account for every kind of goods or services that has been promised under performance obligation depending upon the distinctiveness of the products or services or group of products or services and transfer pattern. There are two criteria that determine distinctiveness of goods and services: Capability of being distinct: The consumer will be benefited from the product or services either by direct consumption or by consuming the same with other resources that are available. Distinct within context of contract: The promise regarding product or service transfer is entirely different from other promises in the contract. A product or service, if not distinct in nature, needs to be combined with other commodities related to the promise unless its distinctiveness is established by the entity (Marshall, 2014; PWC, 2014b). Step 3: Determination of transaction price When the consideration is represented in monetary value, it takes the form of transaction price. An entity is entitled to transaction price after the performance obligation is met in full and final. However, it is noteworthy that the transaction cost does not include cost that has been collected on behalf of third parties. The various factors that need consideration while determining transaction cost are explained as follows: 1. Variable consideration- In some contract, an entity may encounter variable amount of consideration. In such situations, the amount should be determined using probability weighted method. The entity should assume a probable estimation for predicting the amount consideration it is entitled to. 2. Constraining variable consideration estimates- A part or most of the estimate of variable consideration should be included by the entity while considering the fact that the scope of reversibility related to the contract is minimum considering various uncertainty associated with the contract. 3. The existence of significant financial component- The revenue standard suggests that an entity ought to take in account time value of money regarding the promised amount of consideration. The primary reason for the same is that the timing of the disbursement that has been agreed between the parties may result in certain financial benefit to either the consumer or the entity or both for transferring goods or services. An entity must consider a number of factors for determining existence of any financial component that is significant to the contract. However, the financial component need not to be assessed if the entity is informed since the beginning of the contract that the payment will be realised within a year or less of transfer of goods and services. 4. Noncash consideration- when the mode of payment of the consideration is not in the form of cash, it is necessary for the entity to evaluate the consideration amount (noncash) at a fair value. In this context, it is noteworthy that if the reasonable estimation of fair value of expected noncash consideration is not possible then the same should be measured by referring to the standalone selling price of the product (s) and services. Additionally, if the nature of noncash consideration is variable then the guidance on constraining estimation of variable consideration should be followed. 5. Consideration payable to customer- If an entity pays or is suppose to pay certain consideration to the consumer or any other parties that act as third party buyer of the goods or services of the entity either as cash or in non cash form such as coupon, credit or voucher, then the consumer or the third party buyer can consider the value against the amount they owe to the entity. On the part of the entity, the amount can be accounted for by reducing the same from the net transaction cost. However, if the consideration is variable in nature then guidance on constraining estimation of variable consideration should be adopted (Marshall, 2014; PWC, 2014b). Step 4: Allocation of transaction price to the performance obligation in a contract An entity does business with more than one consumer and can sell more than one product to a customer. Consequently, if a contract comprises more than single performance obligation, the entity must allocate the relevant transactional cost to each obligation proportional to the value of the consideration that the entity is entitled to in exchange of full performance of the obligation. In context of transactional price, it is noteworthy that for allocating appropriate consideration amount to every performance obligation, it necessary to estimate the standalone selling price of the distinct products and services. This measure will help the entity to compute the transactional price based on individual selling price in a relative manner. When individual selling price is not directly available, the entity should estimate a value in this regard. It is possible at times that a discount or certain variable consideration is included in the total price of the transaction which is completely relevant to any of the performance obligations within the contract. This condition should be dealt specifically as the discount or variable consideration is applicable to one or some of the performance obligations and not all of those included in the contract. Allocation of any subsequent modification in the transactional price related to performance obligation of in a contract by the entity should have a common base with respect to that of the contract since inception. The amount that is earned by the entity through a satisfied performance allocation is recognised as revenue or decrease in revenue in case of change in transaction price (Marshall, 2014; PWC, 2014b). Step 5: Revenue recognition as performance obligation is satisfied by the entity Revenue should be recognised by an entity as and when it satisfies the consumer with performance obligation through transfer of products and services. By definition, transfer of goods and services is referred to the condition when the consumer gains complete control over the commodities. For every performance obligation, it is necessary that the entity determines if the same was satisfactory in terms of transfer of products and/or services. There are certain criteria which should be met by an entity for revenue recognition after satisfying performance obligation by transferring goods and/or services to the consumers. These are: The goods or services are simultaneously received and its benefits are consumed by the consumer which is provided by the entity’s performance. The performance of the entity should create or enhance any asset which is in possession of the consumer. An appropriate example regarding the same can be work in progress. The performance obligation of the entity may not create any asset that has an alternative usage to the entity; even so, the entity is entitled to payment under law enforcement for the completed performance as on the date. If a particular performance, obligation is not satisfied within its specific timeframe and the entity satisfies the same at any point of time then for determining the specific point of time (when consumer gain complete control over the promised asset and the obligation is fulfilled), a number of factors need to be satisfied as an indicator of transfer of control: The entity acquires the right or is naturally liable to payment for sell of the asset. The consumer gain legal possession of the asset. The entity has ensured transfer of physical possession of the assets. The risk and rewards associated with ownership of the commodity has been passed on to the consumer. The asset has been accepted by the consumer. When an entity satisfies a performance obligation over a span of time, the entity shall account for revenue for that time period by applying any method of determining progress in the process of complete satisfaction of performance obligation in a consistent manner. Measurement of the progress can be ensured through output method and input method. An entity should update its method of progress measurement with respect to change in circumstances and time so as to ensure performance measurement is always up to date (Marshall, 2014; PWC, 2014b). Contrasting opinion regarding effective guidelines of revenue recognition with those in ASU 2014-09 Topic 606 A number of accounting issues between existing revenue recognition guidelines and that of topic 606 were recognised. In this section, the key issues have been discussed briefly: Identifying contract with customer Generally, a contract can verbal, implied and written but ASU imposes a number of criteria which have been discussed earlier. If these criteria are not met then an entity has to reassess the contract time and again so as to ensure that these are met subsequently. The ASU has established probability threshold regarding payment of consideration (collectivity) which does not have any impact of current US GAAP but the requirement changes current practices. It was ascertained that if contract criteria are not met, the realised consideration will be treated as a liability instead of revenue. Furthermore, it was ascertained that technology entities which generally enter in multiple agreement will be affected by ASU regarding contract combination and modification as the guidelines are significantly different from the existing US GAAP (Deloitte, 2014). Identifying performance obligation In step 2, the guidance of ASU regarding determination of ability of goods or services to generate satisfaction on its own or in collaboration with other resources, is consistent with that under ASC 605-25. However, ASU emphasises on determining distinctiveness of the goods and services which may complicates or eliminates the guidelines of ASC 605-25. In current US GAAP, the ASC 985-605 established guidance regarding accounting of multiple element arrangement for software entities where a vendor needs to undertake Vendor Specific Objective Evidence of fair value with respect to each element. However, new guidelines under ASU have eliminated need of VSOE for software arrangement resulting to significant change in accounting of software transactions for technology entities (Deloitte, 2014). Determining transaction price It was ascertained that the ASU emphasises heavily on variable consideration and significant financial components for determination of transaction price. The current US GAAP does not take in consideration future contingency related part in the total price. Additionally, price concessions are considered as deferral to revenue recognition while they are treated as variable consideration under ASU. Additionally, significant divergence can be noticed between current US GAAP and ASU with reference to financial component and contingent revenue (Deloitte, 2014). Allocating transactional cost In the current US GAAP, the multiple element arrangement is accounted under ASC 985-605 which prohibits residual method of cost allocation and emphasises on determination of selling price based on hierarchy of evidence. The ASU implements a number of measures such as adjusted market assessment and expected cost plus margin along with residual approach for determination of selling price and allocation of the same. From the perspective of multiple element arrangement, the elimination of selling price hierarchy and dependency on residual method can result in differences between ASU and current US GAAP (Deloitte, 2014). Recognising revenue when performance obligations are satisfied Under ASC 605-25, entities currently follow either percentage of completion method or completed contract method for recognition of revenue. This technique bears certain similarities with the ASU as it proposes that when an entity creates a complete or partial asset for consumer, revenue should be recognised in proportion to the amount of work done (Deloitte, 2014). Comment on the difference between existing and new guidelines on revenue recognition The fundamental differences between current US GAAP and ASU in terms of revenue recognition principle are as follows: Transfer of control model: In ASU, Revenue is recognised as satisfaction is created from every performance obligation. This concept is different current and previous US GAAP because these focussed on transfer of rewards and risks associated with the asset for determination of revenue realisation. Variable consideration: Contrasting to the US GAAP, ASU estimates various variable considerations such as bonus or penalty to the extent where probability of reversal in net revenue because of the same is minimised through resolving of underlying uncertainty. Time value of money: The ASU emphasises on inclusion of time value of money while determining transaction price and consolidated amount of recognised revenue. The primary reason for the same is to enhance benefit of the time of value of money to consumer and entity as and when applicable. Multiple agreement arrangements: the ASC 606 is to a great extent similar to the guidelines of ASC 605 but there are certain differences which should be considered. The ASC 605 considers an element to have separate standalone value if it is sold separately. Contrastingly, ASC 606 ensures that the distinctness of the element is proved through consideration of various factors. While both the standards implement relative selling price method for allocation of arrangement consideration, the ASC 606 focuses on incremental guidance for certain specific conditions (Bond, 2014). Conclusion In 2014, significant changes have proposed in the revenue recognition principle of current US GAAP through accounting standard update. The paper critically assesses and contrasts the similarities and difference between existing US GAAP and the ASU. The ASU was proposed by the IASB and FASB for increasing successful convergence between IFRS and US GAAP. The analysis resulted in uncovering of certain significant differences between ASU and existing US GAAP which is expected to enhance transparency in reporting regarding revenue recognition in near future. References AICPA. (2014). Significant Changes Coming to U.S. GAAP. Retrieved from http://www.aicpa.org/INTERESTAREAS/FRC/ACCOUNTINGFINANCIALREPORTING/Pages/AFR_Significant_Changes_Coming_to_US_GAAP.aspx. Bond, J. (2014). An analysis of the new revenue recognition guidance issued by FASB & IASB. Retrieved from http://www.decosimo.com/downloads/Article_FASB_Revenue_Recognition.pdf. Deloitte. (2014). Technology Spotlight — the future of revenue recognition. Retrieved from http://www.iasplus.com/en-us/publications/us/industry-spotlight/tech/revenue. Ernst & Young. (2014). Revenue recognition multiple element arrangements: Accounting Standards Codification 605-25. Retrieved from http://www.ey.com/publication/vwluassetsdld/financialreportingdevelopments_bb1843_revenuerecognition_multipleelement_19may2014/$file/financialreportingdevelopments_bb1843_revenuerecognition_multipleelement_19may2014.pdf?OpenElement. FASB. (2009). Multiple deliverable revenue arrangements. Retrieved from http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176156475499&acceptedDisclaimer=true. FASB. (2014a). IASB and FASB issue converged standard on revenue recognition. Retrieved from http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FNewsPage&cid=1176164075286. FASB. (2014b). Revenue recognition. Retrieved from http://www.fasb.org/jsp/FASB/Page/BridgePage&cid=1351027207987. FASB. (2014c). Accounting Standards Update 2014-09: revenue from Contracts with Customers (Topic 606).Retrieved from http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176164076069&acceptedDisclaimer=true. Gallistel, D.J., Phan, T., Bartlett, G.D. & Dodd, J.L. (2012). IASB & FASB Convergence Project: Revenue Recognition. Drake Management Review, 2(1), 37-50. Marshall, B.H. (2014). Revenue recognition: A whole new world. Retrieved from http://mcgladrey.com/content/dam/mcgladrey/pdf_download/wp_revenue-recognition-a-whole-new-world.pdf. PWC. (2014a). In depth: Revenue standard is final – A comprehensive look at the new revenue model. Retrieved from http://www.pwc.com/us/en/cfodirect/publications/in-depth/new-revenue-recognition-model-us2014-01.jhtml?display=/us/en/cfodirect/issues/revenue-recognition. PWC. (2014b). New FASB, IASB revenue recognition rules could have significant US tax implications. Retrieved from http://www.pwc.com/en_US/us/tax-services/publications/insights/assets/pwc-new-revenue-recognition-rules-have-big-us-tax-implications.pdf. Bibliography Chartered Accountants Australia and New Zealand. (2014). Revenue recognition. Retrieved from http://www.charteredaccountants.com.au/Industry-Topics/Reporting/Current-issues/Convergence/News-and-updates/Revenue-Recognition.aspx Deloitte. (2014). Revenue recognition. Retrieved from http://www.iasplus.com/en/projects/completed/revenue/revenue-recognition. FASB. (2014a). Technical Corrections and Improvements. Retrieved from http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176160388752&acceptedDisclaimer=true FASB. (2014b). International convergence of accounting standards—a brief history Retrieved from http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156304264. KPMG. (2014). US GAAP conversions. Retrieved from http://www.kpmg.com/uk/en/services/audit/us-accounting-reporting-group-usarg/pages/us-gaap-conversion.aspx. Read More