Are you ready for the new revenue recognition standard? Do you know how transitioning from ASC 605 / SAB 104 to ASC 606 (or IFRS 15) Revenue from Contracts with Customers will affect your organization? If not, you’re in luck! In our new series of blog posts, we walk through the new five-step model, step-by-step, to get you prepared!
ASC Topic 606 prescribes a new five-step model that entities should follow in order to recognize revenue. These five steps are:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfied the performance obligations.
In this post, we will focus on step 2: Identify the performance obligations in the contract, specifically the changes, if any, to existing guidance.
According to ASC Topic 606, 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 good 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 customer 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. 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.
Many entities were already identifying “performance obligations” under existing guidance for multiple-element arrangements found within ASC Subtopic 605-25. However, under the new guidance, all entities will be required to do this analysis. Let’s take a look at an example.
Willie’s Whiteboards sells extremely large whiteboards to corporate clients around the world. Willie’s has standard sales contracts containing free on board (FOB) shipping point terms, with title legally transferring at the time of shipment. At the same time, Willie’s has a history of replacing or crediting lost or damaged shipments. When a customer complains about lost or damaged products, Willie’s authorizes its customer service department to give the customer a credit or to replace the damaged whiteboard without charge. A credit or replacement must be given for a complete or partially lost or damaged shipment. Over the past four years, claims from Willie’s customers averaged 0.8% of total orders and 0.4% of total revenues. Willie’s has reimbursed all claims for each of the last four years.
Question 1: Does Willie’s practice of replacing products or issuing credits for lost or damaged product affect the timing of revenue recognition under ASC 605 / SAB 104?
Question 2: How would Willie’s actions impact revenue recognition under the new standard?
Answer to the first question: Old Guidance (ASC 605 / SAB 104)
Yes. In this situation, all of the significant risks and rewards of ownership have not transferred to the buyer at the time the product ships. Willie’s practice of compensating customers for lost or damaged product results in “synthetic” FOB destination shipping terms. As a result, revenue for all shipments must be deferred until the product has been received and accepted by the customer.
According to the SEC, the insignificance of historical claims to the total orders or revenue is irrelevant as Willie’s has never required a customer to pay for a damaged or lost product. As result of Willie’s business practices, the customer is essentially in the same position as if the shipping terms were FOB destination.
In this example, Willie’s has a history of reimbursing its customers for all situations where goods have been lost or damaged in transit. It is clear that Willie’s would be regarded as having a past practice of reimbursing customers for losses incurred in transit and, thus, should defer all revenue until the customer receives and accepts the goods.
However, if Willie’s has reimbursed just one customer, and for only one loss out of a number of losses incurred in transit, Willie’s past practice would likely support management’s assertion that it has a policy of not covering a buyer’s losses while goods are in transit.
The difficulties arise in this assessment when the facts lie somewhere between those two extremes. Willie’s must analyze and understand the reasons for the particular reimbursements to determine whether a specific customer or class of customer, or a particular type of product sales, are routinely covered by Willie’s. When such a pattern is discernible, Willie’s should defer revenue recognition for such sales until the customer receives and accepts the goods.
Answer to the second question: New Guidance (ASC 606)
Depending on its judgment as to whether or not activities in the contract were considered distinct, Willie’s might conclude that it has three separate performance obligations:
- Selling the product
- Covering the risk of loss of the product during transit based on past business practice
- Arranging shipping and handling
The transaction price would be allocated to each performance obligation based on the guidance within ASC Section 606-10-32. Revenue would be recognized when (or as) Willie’s satisfies each performance obligation. We will cover these steps in subsequent blog posts.
It should be noted that shipping and handling was an issue that was raised with the Transition Resource Group (TRG). Specifically, whether or not these activities were distinct and, therefore, a separate performance obligation. Check out this post related to the accounting for shipping and handling under ASC 606.
The separation criteria within current U.S. GAAP (ASC 605 / SAB 104) focuses on whether the delivered goods or services are separable from other goods and services but has no criteria for undelivered goods or services. However, under the new standard (ASC 606), entities must consider all performance obligations that exist in the contract and this must be done at contract inception. This will be a change for some companies and require significant judgment from management to determine whether or not promised goods or services are distinct.