The 5-step model within IFRS 15 and ASC 606 applies to ALL contracts with customers, regardless of industry, unless the contract is within the scope of other guidance (for example, leases within the scope of ASC 842).
In this section, we’ll walk through each of the 5 steps that must be applied to recognize revenue arising from a contract with a customer and focus on a few of the application issues with more widespread relevance across industries and transactions.
Step 1: Identify the contract(s) with a customer
A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral, or implied by an entity’s customary business practices.
An entity should account for a contract with a customer that is within the scope of ASC 606 only when all of the following criteria are met:
- The parties to the contract have approved the contract and are committed to perform their respective obligations.
- The entity can identify each party’s rights regarding the goods or services to be transferred.
- The entity can identify the payment terms for the goods or services to be transferred.
- The contract has commercial substance.
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
If an arrangement fails to meet all of these criteria at contract inception, it does not qualify as a contract, and no revenue should be recognized under either ASC 606 or IFRS 15. The entity should continue to re-evaluate these criteria each reporting period until the contract meets the criteria.
Accounting issue: Change in collectibility of a contract
While step 1 seems fairly straightforward, sometimes its application can pose a challenge. One aspect of identifying a contract is to ensure it is probable (or highly probable under IFRS) that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. If collectability is not probable, then you don’t really have a contract and no revenue should be recognized.
What happens if a contract is deemed collectible at contract inception, but subsequently, perhaps even years after the contract was established, collectibility is no longer probable?
If a contract with a customer meets the criteria in Step 1 at contract inception, an entity does not reassess those criteria unless there is an indication of a significant change in facts and circumstances. The assessment of whether a significant change in facts and circumstances occurred is situation-specific and often a matter of judgment. If such a significant change does occur, and collectibility is no longer probable, the entity is precluded from recognizing additional revenue under the contract until collectibility again becomes probable or the entity receives nonrefundable consideration and other criteria are met (e.g., performance has been completed, the contract is terminated, etc.).
Step 2: Identify performance obligations
According to ASC 606 and IFRS 15, a performance obligation is a promise in a contract with a customer to transfer to the customer either:
- A good or service (or bundle of goods or services) that is distinct, or
- A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
A good or service that is promised to a customer is distinct if both of the following criteria are met:
- The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.
- The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.
If a promised good or service is not distinct, an entity combines that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, all the goods or services promised in a contract would be treated as a single performance obligation.
Generally, a contract with a customer explicitly states the goods or services that an entity has promised to a customer, but not always. This is because a contract with a customer may also include promises that are implied by an entity’s customary business practices, published policies, or specific statements. If, at the time of entering the contract, those promises create a valid expectation of the customer that the entity will transfer a good or service to a customer, these promises could also be performance obligations. However, performance obligations do not include activities that an entity must undertake to fulfill a contract, unless those activities transfer a good or service to a customer.
Accounting issue: Warranties
ASC 606 and IFRS 15 introduce two types of warranties: service-type warranties and assurance-type warranties.
If the customer has the option to purchase the warranty separately or if the warranty provides a service to the customer beyond fixing defects that existed at the time of sale, the entity is providing a service-type warranty. The Boards determined that this type of warranty represents a distinct service and is a separate performance obligation. Therefore, the entity allocates a portion of the transaction price to the service-type warranty based on the estimated standalone selling price of the warranty. The entity then recognizes revenue allocated to this type of warranty over the period the warranty service is provided.
The Boards concluded that assurance-type warranties do not provide an additional good or service to the customer (i.e., not a separate performance obligation). By providing this type of warranty, the selling entity has effectively provided a guarantee of quality. Under the standard, these types of warranties are accounted for as warranty obligations, and the estimated cost of satisfying them is accrued in accordance with other relevant guidance.
Certain arrangements may include both an assurance-type warranty and a service-type warranty. However, if an entity provides both an assurance-type and service-type warranty within an arrangement and the entity cannot reasonably account for them separately, the warranties are accounted for as a single performance obligation (i.e., revenue would be allocated to the combined warranty and recognized over the period the warranty services are provided). When an assurance-type warranty and a service-type warranty can be accounted for separately, an entity is required to accrue for the expected costs associated with the assurance-type warranty and defer the revenue for the service-type warranty.
We discuss the accounting for both types of warranties in this post.
Step 3: Determine the transaction price
In step 3, we determine the amount the entity expects to receive for satisfying the performance obligations in revenue contracts with customers. This transaction price may include fixed amounts set forth in the contract, variable amounts, or both. It might also include adjustments for significant financing arrangements (i.e., time value of money) or the fair value of any non-cash consideration received.
Variable consideration is very broadly defined and can be either explicitly or implicitly set forth in the contract. Variability takes many forms and includes discounts, rebates, customer incentives, refunds, credits, performance bonuses, penalties, contingencies, and price concessions.
To estimate variable consideration, entities use one of two methods and apply the method consistently throughout the term of the contract:
- Expected value: the sum of an entity’s probability-weighted estimates.
- Most likely amount: the amount with the highest likelihood of occurrence in a range of possibilities.
When estimating variable consideration, entities should only include amounts they are likely to realize and, therefore, not subject to significant revenue reversal (sometimes referred to as the “revenue constraint”). In making this determination, entities need to consider factors that might increase the chances of revenue reversal.
Accounting issue: Significant financing component
The guidance states that time value of money is reflected in a vendor’s estimate of the transaction price if the contract has a financing component that is significant to the contract using the discount rate that would be reflected in a separate financing transaction between the vendor and the customer at the inception of the contract. Any financing component is recognized as interest expense (when the customer pays in advance) or interest income (when the customer pays in arrears). An entity should consider all relevant facts and circumstances in assessing whether a contract contains a financing component and whether that financing component is significant to the contract. If so, financing component must be presented separately. You can see an example of this guidance here.
This might seem counterintuitive, but a practical way to look at it is that the customer provided the vendor with financing that it would otherwise have had to obtain from another party, thus incurring interest expense. In order to account for this, revenue is “grossed up” using the same discount rate that the vendor would use if it were to enter into a separate financing transaction with the customer. Interest expense is then recognized over time.
There is also practical expedient whereby time value of money can be ignored for periods that are one year or less.
Step 4: Allocate the transaction price to the performance obligations
The whole objective of step 4 is to allocate the transaction price to the various performance obligations identified in step 2 so that we can recognize a reasonable amount of revenue when those performance obligations are satisfied. This allocation is referred to as the relative standalone selling price approach.
At a high level, the standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. The best evidence of this standalone price is the observable price of a good or service when the entity actually sells that good or service separately in similar transactions. Although contract prices may represent the standalone selling price of that good or service, this is not always the case.
Oftentimes, actual standalone selling prices do not exist, and entities must use an estimation method in order to properly allocate the transaction price. This estimation should always seek to maximize observable inputs, and estimation methods may include:
- An adjusted market assessment approach,
- An expected cost plus a margin approach; or
- A residual approach (but only in limited circumstances).
Accounting issue: Allocation of discounts to the various performance obligations
Normally, an entity allocates any discounts, proportionately, to all the performance obligations in the contracts. However, if an entity has observable evidence the entire discount relates to just certain performance obligations, then the entity allocates a discount entirely to one or more, but not all, performance obligations in the contract, assuming all of the following criteria are met:
- The entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in the contract on a standalone basis.
- The entity also regularly sells on a standalone basis a bundle (or bundles) of some of those distinct goods or services at a discount to the standalone selling prices of the goods or services in each bundle.
- The discount attributable to each bundle of goods or services described above in (b) is substantially the same as the discount in the contract, and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation (or performance obligations) to which the entire discount in the contract belongs.
If a discount is allocated entirely to one or more performance obligations in the contract, an entity allocates the discount before using the residual approach to estimate the standalone selling price of a good or service
Want to see step 4 in action? Check out this video!
Step 5: Recognize Revenue
We have now reached the culmination of the 5-step model. At this point, entities need to determine the timing of their revenue recognition, which should be based on when control of the underlying good or service is transferred to the customer. Control in this context refers to the ability to:
- Direct the use of, and obtain substantially all the benefits from, an asset (i.e., the asset’s potential indirect or direct cash flows), OR
- Prevent other entities from directing the use of, and obtaining the benefits from, an asset.
Based on the nature of a revenue contract, customers may obtain control of the related asset either over time or at a point in time. But this is not a choice. You have to EARN revenue recognition over time by meeting one of the following criteria:
If control transfers over time, an entity will recognize revenue over the period it satisfies the related performance obligation utilizing a method (i.e., input or output method) that best depicts the progression toward satisfying the performance obligation. Think the percentage-of-completion method used by construction companies. Regardless of what method they choose, entities need to apply the method consistently to similar performance obligations and in similar transactions or arrangements.
When control does not transfer over time, entities must determine the point in time in which control of the underlying asset transfers to a customer based on the applicable facts and circumstances.
Accounting issue: Recognizing revenue gross as principal or net as agent
Determining whether revenue should be recognized gross as the principal or net as an agent is a “hot topic” with accountants and auditors alike. Why? Because if you get it wrong, your income statement can be grossly overstated or understated with respect to the revenue that is reported. So, getting it right is very important, although it can require a significant amount of judgment.
One of the keys to determining whether an entity is a principal or agent in a transaction is to determine the nature of its promise to the customer, which includes considering:
- Identifying the specified goods or services to be provided to the customer; and
- Assessing whether it controls each specified good or service before that good or service is transferred
to the customer.
An entity is a principal if it controls the specified good or service before that good or service is transferred to a customer. If an entity is a principal, it presents revenue and cost of sales on a gross basis. Alternatively, if an entity does not control the good or service before it is transferred to the customer, the entity is an agent in the transaction. Agents present revenue net of the related cost of sales in the income statement. In other words, agents basically only report their “commission” as revenue.
Control is defined within step 5 and refers to the ability to direct the issue of, and obtain substantially all the remaining benefits from, the asset. However, it is not always clear whether a customer obtains control of the specified good or service. Luckily, ASC 606 and IFRS 15 provided the following three indicators of control that can be useful in determining who is the principal in the transaction:
- The entity is primarily responsible for fulfilling the promise to provide the specified good or service.
- The entity has inventory risk before the specified good or service has been transferred to a customer, or after transfer of control to the customer (for example, if the customer has a right of return).
- The entity has discretion in establishing the prices for the specified good or service.
Want to learn more about principle vs. agent determination and why it matters? Check out this post!
Accounting Differences: ASC 606 vs. IFRS 15
While ASC 606 and IFRS 15 are mostly converged, there still are a few differences which arose when the FASB issued a string of ASUs after both Boards issued their final standards. Although this is not an all-inclusive list, here are the top differences between U.S. GAAP and IFRS related to revenue:
‘Probable’ means ‘likely’
‘Probable’ means ‘more likely than not’
Collectibility is assessed for the goods or services that will be transferred to the customer rather than for all promised goods or services.
No equivalent guidance.
Shipping and handling activities
An accounting policy election to treat shipping and handling activities undertaken by the entity after the customer has obtained control of the related goods as a fulfillment activity.
No equivalent policy election.
Promised goods or services that are immaterial
Goods or services that are immaterial in the context of the contract need not be identified as performance obligations.
No equivalent guidance.
Noncash consideration is measured at contract inception.
Judgment is required to determine the measurement date for noncash consideration.
Determining the nature of an entity’s promise in granting a license of intellectual property (IP)
Classify IP as either functional or symbolic. Revenue for all licenses to symbolic IP is recognized over time.
Although most licenses to symbolic IP would be recognized over time, revenue may be recognized at a point in time in those cases in which the entity will undertake no activities that significantly affect the ability of the customer to obtain benefit from the IP during the license period.
Renewals of licenses of IP
Renewals subject to ‘use and benefit’ guidance, which generally will result in revenue recognition at the beginning of the renewal period.
‘Use and benefit’ guidance does not explicitly refer to renewals. This may result in the recognition of revenue earlier than under Topic 606.
Presentation of sales (and other similar) taxes
An accounting policy election to exclude from the measurement of the transaction price sales and similar taxes that are both imposed on and concurrent with the specific revenue-producing transaction and collected from customers.
No equivalent policy election.
Nonpublic entity requirements
Applies to nonpublic entities and includes some specific reliefs relating to disclosure, transition, and effective date.
No equivalent guidance.
Check out this post for further discussion of the GAAP differences noted above.
Join the Revolution with GAAP Dynamics!
GAAP Dynamics training courses are designed to help leading accounting firms, multinational companies, and even the individual CPA move beyond the training status quo! If you’re sick and tired of click-fests or talking heads, our eLearning is for you! Our courses are continually updated, and new courses are constantly being added, so check back often! Below are our courses related to revenue recognition.
Revenue: Overview of ASC 606 (1.0 CPE) – Start your ASC 606 journey here! This course provides an overview of the requirements of ASC 606, including the 5-step model for recognizing revenue. In addition, it discusses the impact of ASC 606 on various industries.
Revenue: Specific Issues (1.0 CPE) – This module dives into some specific issues associated with ASC 606 Revenue from Contracts with Customers. Do you know how to identify a material right in a contract? What about identifying whether you are a principal or an agent? How about accounting for contract modifications? No worries. We’ve got you covered! We’ll also cover practical application issues associated with the 5-step model such as accounting for warranties and right of return.
We’ve bundled our existing eLearning courses into an ASC 606 collection for big savings!
And we have more courses on the way! We’re planning to release a course for each step in the 5-step model.
- Revenue: Identify the Contract with the Customer (Step 1 of ASC 606) (0.5 CPE) – Coming soon!
- Revenue: Identify Performance Obligations (Step 2 of ASC 606) (1.0 CPE) – Coming soon!
- Revenue: Determine the Transaction Price (Step 3 of ASC 606) (1.0 CPE) – Coming soon!
- Revenue: Allocate Transaction Price (Step 4 of ASC 606) (0.5 CPE) – Coming soon!
- Revenue: Recognize Revenue Over Time or at a Point in Time (Step 5 of ASC 606) (1.0 CPE) – Coming soon!
There are numerous resources available related to revenue recognition from contracts with customers under both ASC 606 and IFRS 15. To save you time, we’ve compiled a list of resources below to assist you in your journey to learn more about this exciting topic!
Resources from GAAP Dynamics:
We’ve written several blog posts on a variety of topics related to recognizing revenue from contracts with customers. Click on the links below to learn more.
Step-by-Step – Differences in ASC 605 / SAB 104 and ASC 606
This series of posts examines each step in the new five-step revenue recognition model and compares the new guidance to the old guidance under ASC 605 / SAB 104. Each step includes a series of practical examples or questions that reviews the proper accounting under the old standard and highlights how the answer will change under the new standard.
- Step 1– Identify the contract (November 17, 2015)
- Step 2– Determine the Performance Obligations (November 25, 2015)
- Step 3– Determine the Transaction Price (December 1, 2015)
- Step 4– Allocate the Transaction Price to the Performance Obligations (December 8, 2015)
- Step 5– Recognize Revenue (December 15, 2015)
Comparing the New Revenue Recognition Standards: IFRS 15 and ASC 606 (August 30, 2016)
As originally issued, IFRS 15 and ASC 606 were very similar with little difference between the two standards. However, four ASUs later, the standards are moving further apart. This post will take a look at some of the main differences between the two standards as a result of the new guidance.
Technical Corrections to ASC 606: The New Revenue Recognition Standard (February 14, 2017)
The FASB issued ASU 2016-20 to clarify several inconsistencies that stakeholders pointed out through the Revenue Recognition Transition Resource Group (TRG) or other feedback mechanisms. This ASU addresses 13 specific issues, but in the interest of being as brief as possible, this post only covers what we believe are the more significant or pervasive corrections covered in ASU 2016-20.
Five Nuggets from the SEC About ASC 606 Transition (February 21, 2017)
What does the SEC have to say about transition to ASC 606? Do they have any insight, particularly related to compliance with their reporting requirements? Well, they have provided some recent comments. In this post we focus on five of those insights, or “nuggets”, shared by the SEC at the AICPA Conference held in December 2016.
Don't Be A Control Freak! Revenue Recognition Criteria (ASC 606 and IFRS 15) (March 21, 2017)
Who gets into a disagreement with a prospective client about application of accounting at a trade booth? Me, that’s who! But I had a good reason. She was misinterpreting the revenue recognition criteria within the new revenue standard (ASC 606 and IFRS 15) and I had to save her from herself (and her auditors). This post explores the concept of control within the new standards.
A Shortcut For Implementing The New Revenue Standard (ASC 606 / IFRS 15)? (October 17, 2017)
It came to our attention that companies were sampling their various revenue contracts in order to transition to ASC 606. Is this allowed? This post explores our research into the subject based on an actual participant question on the topic.
Goodbye ASC 605, Hello 606! Five Non-Revenue Impacts (July 21, 2015)
When switching from ASC 605 to the new revenue recognition standards (ASC Topic 606 or IFRS 15), do you believe the switch only affects revenue? Many believe this to be true, which is not unreasonable given the new standards are titled Revenue from Contracts with Customers. However, these new, principles-based accounting standards also introduce guidance that will directly impact many areas of financial reporting, not just when and how companies record revenue. And these might lead to differences in your current accounting practices. This post takes a look at some of the non-revenue impacts of the new standards.
Principal vs. Agent GAAP Revenue Recognition Criteria (ASC 606) (April 4, 2017)
Should you report revenue gross as a principal or net as an agent? This post provides an overview of the principal vs. agent guidance within ASU 2016-08, Principle versus Agent Considerations (Reporting Revenue Gross versus Net).
Shipping and Handling: New Revenue Recognition Standard (ASC 606) (March 14, 2017)
Do you look at the cost, or lack thereof, related to shipping and handling when you purchase goods online? In other words, do you value shipping and handling services provided by sellers or resellers of goods? Do you think it should it be considered a separate performance obligation by the seller under the new revenue recognition standard (ASC 606)? In this post, we cover the accounting for shipping and handling activities, specifically whether they should be treated as separate performance obligations.
PCAOB Staff Alert No. 15 - Auditing the Revenue Recognition Standard (October 24, 2017)
The PCAOB released Staff Practice Alert No. 15, Matters Related to Auditing Revenue from Contracts with Customers. Although SAPAs do not represent authoritative guidance, they highlight any new, emerging, or otherwise important circumstances that may impact how auditors perform their audits. However, we believe this SAPA represents a great roadmap for companies about how to prepare for the audit of their implementation of the new standard. This post provides an overview of SAPA No. 15.
Taxes and the New Revenue Recognition Standard (ASC 606) (December 5, 2017)
Since the new revenue recognition standards were released, accounting departments have been spending countless hours working to understand and implement the new rules. But what effect will the new standard have on tax returns and taxable income? This post summarizes how the changes under the new revenue recognition standard (ASC 606) may impact tax filing and compliance.
Gunga Galunga: Accounting for Nonrefundable Initiation Fees under ASC 606 (January 23, 2018)
I’m eating lunch at a dive bar in the Himalayas and who sits down to eat with me? The Dalai Lama himself. Twelfth son of the Lama. The flowing robes, the grace, bald…striking. So, we order our lunch – big eater, the Lama – and, as he’s wolfing down his yak tacos, he asks me about the accounting for upfront, nonrefundable initiation fees. Specifically, he wanted to know if adopting ASC 606 Revenue from Contracts with Customers would impact the accounting policies of his local golf club. This post recaps our conversation!
Examining Contracts under ASC 606: Material Rights (May 8, 2018)
Since the issuance of ASC 606, accountants have worked to understand the new 5-step model and its effect on their companies. Step 2 has proved the most difficult, especially if an entity does not have standard contract terms, the contract contains multiple products or services, or if there are options included for the acquisition of future products or services. This option to acquire future products or services can give rise to material rights, which impacts the amount of revenue recognized. This post provides an overview of the accounting for materials rights under ASC 606.
To Buy or Not to Buy? Accounting for Warranties under ASC 606 (May 29, 2018)
We have all been there, and for me, it happened just last week. After an incident at my house where a ball mysteriously hit the television, I made a trip over to the electronics store. As I’m getting ready pay, the clerk asks, “Would you like to purchase the 3-year extended warranty?” Questions quickly flew through my head… How risky am I feeling today? What warranty automatically comes with the TV? What are the chances my kids will break another TV within 3 years? Then the accounting nerd in me took over. How should I account for the additional warranty purchase under ASC 606? So, I wrote a post on it!
Unanswered Questions in ASC 606: Shipping and Handling (July 3, 2018)
As you probably know by now, ASC 606, Revenue from Contracts with Customers, is quite extensive and provides considerable guidance. While extensive, it can’t possibly cover all of the related issues that might arise in practice. In this blog, we’ll explore one of those unanswered questions, related to shipping and handling activities.
Unanswered Questions in ASC 606: Pre-Production Arrangements (July 10, 2018)
While ASC 606 is extensive, it can’t possibly cover all of the issues related to revenue recognition that might arise in practice. In a previous post we covered one of these issues related to shipping and handling activities. This week, I thought I’d explore another unanswered question on the topic of pre-production arrangements.
Recognizing Revenue under ASC 606 when Good Contracts Go Bad (May 7, 2019)
ASC 606 requires us to consider collectibility to determine if a contract exists but what happens if things change after the contract is signed? Can the company continue to recognize revenue? This post explores if, and when, an entity may need to re-evaluate the collectibility of a contract, and what it means for revenue recognition.
Consideration of a Significant Financing Component under ASC 606 (September 3, 2019)
Did you know that ASC 606 requires consideration of a significant financing component when determining the transaction price for revenue recognition? This post explores when and how that significant financing component should be recognized.
Resources from the FASB and IASB:
Resources from Accounting Firms:
The Big 4 accounting firms have published informative and thorough guides related to recognizing revenue from contracts with customers. To save you time, we’ve linked to the most recent versions below.
- KPMG: Handbook: Revenue Recognition
- PwC: Accounting Guide: Revenue from Contracts with Customers
- EY: Financial Reporting Developments – Revenue from Contracts with Customers (ASC 606)
- Deloitte: A Roadmap to Applying the New Revenue Recognition Standard