Breaking Down the Proposed New Revenue Recognition Standard: Steps 1 & 2

The Financial Accounting Standards Board and the International Accounting Standards Board have been working on a joint project concerning revenue recognition. Why is this important to Anders clients and colleagues? Because any entity that enters into a contract with a customer will be affected by this new standard (except for insurance and lease contracts).

An entity would follow these steps in determining when and how much revenue to recognize for a contract under the new proposed standards:

  1. Identify the contract with a customer,
  2. Identify the separate performance obligations in a contract,
  3. Determine the transaction price,
  4. Allocate the transaction price to the separate performance obligations in the contract, and
  5. Recognize revenue when (or as) the business satisfies a performance obligation.

Step 1: Identify the contract with a customer
The proposed standard defines a contract as an agreement between two or more parties that creates enforceable rights and obligations, and can be oral, written, or implied by an entity’s customary business practices. In some instances, an entity may be required to combine two or more contracts entered into with a customer at the same time (or near the same time) and account for those contracts as a single contract.

Step 2: Identify the separate performance obligations in a contract
Performance obligations are defined in the proposed standard as a promise in a contract with a customer to transfer a good or service to the customer. The entity would account for each distinct promised good or service within the contract as a separate performance obligation. Goods or services may include inventory produced by a manufacturer, inventory purchased by a distributor or retailer for resale, or an asset constructed for a customer. In order for a good or service to be distinct, either of the following criteria should be met:

  1. The entity regularly sells the good or service separately.
  2. The customer can benefit from the good or service either on its own or together with other readily available resources.

Apart from above criteria, a contract that contains a bundle of goods or services, and no one good or service can be identified as distinct, shall be accounted for as one performance obligation if both of the following criteria are met:

  1. The goods or services in the bundle are highly interrelated and transferring them to the customer requires a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted.
  2. The bundle of goods or services is significantly modified or customized to fulfill the contract.

Contact your Anders trusted advisor to learn more about how the proposed standard could affect your company, and stay tuned to www.graymatterblog.com for outlines of steps three through five.