After many years of study and analysis, the Financial Accounting Standards Board (FASB) issued a new Accounting Standards Update earlier this summer regarding the appropriate accounting treatment for revenue going forward.
As revenue is a critical financial measure for companies and stakeholders, how it is recognized on financial statements can have a tremendous effect on the entity’s future, including its ability to attract investors and borrow money.
The new rules from FASB, outlined in ASU No. 2014-09, are an attempt to correct identified weaknesses and areas for improvement in the accounting for revenue under current standards, as well as converge the methodology used in the U.S. with that around the globe. It also aims to standardize revenue recognition practices across different industries and markets, improve the usefulness of required financial statement disclosures and make them easier to prepare.
As a guiding principle, the FASB standards state: “Revenue should be recognized in a way that reflects the transfer of promised goods or services to customers. The amount of revenue recognized should be equal to the consideration that the company expects to be entitled to for the promised goods or services.”
ASU No. 2014-09 lays out a five-step approach for recognizing and measuring revenue:
- Identify the contract with the customer — This defines an agreement between two or more parties on enforceable rights and obligations, payments and so forth.
- Identify the contract’s separate performance obligations — A performance obligation is a promise in the contract with a customer to transfer a distinct good, service or bundle of goods and services.
- Determine the transaction price — An entity must determine the transaction price based on the terms of the contract and the entity’s customary business practices, less amounts collected on behalf of third parties (such as taxes).
- Allocate the transaction price to the separate performance obligations — This is done by determining the standalone selling price of the good or service associated with the performance obligation, and allocating them within the total transaction price.
- Recognize revenue as the entity satisfies a performance obligation — A performance obligation is satisfied when an entity transfers a promised good or service to its customer, which is deemed to occur when the customer obtains control of the item.
The new rules also contain a subtopic on contract costs to provide guidance on whether a company must capitalize or expense contract costs.
ASU No. 2014-09 is effective for annual reporting periods beginning after Dec. 15, 2016 for public entities and after Dec. 31, 2017 for nonpublic entities. There are limitations on early adoption. The FASB established these deadlines to give companies time to consult with their financial advisors so they can best comply with these significant changes in revenue recognition rules and incorporate them into their ongoing business goals.
If you need any guidance about the changes to revenue recognition standards, please contact Mike Bedel at (317) 613-7852 or email [email protected].