Revenue Recognition

In May of 2014, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) issued a new joint standard on revenue recognition.  The initiative will create one globally accepted standard, and will replace the present US GAAP and IFRS standards of over 200 ways to recognize revenue.   The goal was to create a framework for revenue recognition that will be applied consistently across transactions, industries, and capital markets, and will improve the comparability of the financial statements of firms globally.  This framework is encompassed in the Five Step Model, which will be discussed in depth here.  All firms operating under GAAP and IFRS must begin to practice this new standard by Jan 1, 2017.  

One of the key components that investors and analysts look at when assessing the financial health of a firm is revenue.  Presently, GAAP has complex and disparate revenue recognition requirements for specific transactions and industries, for example, engineering, and construction.  The result is similar transactions can be accounted for differently depending on the industry, which makes it hard for an investor to get a true understanding of a firm’s revenue.  By enforcing the new standard, all firms will be recognizing revenue under the same set of rules, which will result in greater comparability among companies across industries.  The new standard hopes to provide clarity on the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.  It will also address when to recognize revenue, and at what amount, stating that “revenue should be recognized when an (or as) an entity transfers control of goods or services to a customer at the amount to which the entity expects to be entitled.”  In other words, revenue can only be recognized when certain obligations are met.

All firms must use the five-step model when recognizing revenue.  The steps are as follows:

1. Identify the contract.  

2. Identify performance obligations.  

3. Determine the transaction price.

 4. Allocate the transaction price.

5. Recognize revenue.  

For some firms, applying the five-step model will continue to be business as usual.  For others, significant changes may result in how revenue is recognized using this model.  Firms that deal with long term contracts – i.e. defense or construction industries for example, could see significant changes to the timing of revenue recognition.  The new standard also provides guidance on how to apply warranties and licenses and when to capitalize the inventory costs of obtaining or fulfilling a contract, which may not have been addressed in previous standards.

The timing of when to apply the new standard is especially crucial.  A contract with a customer may be partially in the scope of the current standard and partially in the scope of the new standard. An example would be a contract for a lease of computer services and maintenance of the leased equipment or financial services contract with a cash deposit and treasury services.  In instances like this, the firm must first apply the specific guidance that applies to the current standard and for the remainder of the contract, apply the new revenue standard.  The new standard also allows a firm to apply the requirements to a portfolio of contracts with similar characteristics if the outcome is not materially different from accounting for the contracts individually.