Last week we announced our three-part blog series on everything you need to know about the impending revenue recognition standard.
If you haven’t started implementing, which it seems most companies haven’t, it’s time to get started. What better place to start than by familiarizing yourself with the basics of this major accounting standard update? Today’s post boils down the 5 Ws in a simple, concise manner with information pulled from various sources, so you don’t have to spend hours reading up on it.
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It is an update to the revenue recognition standard, specifically where contracts with customers are concerned. The final objective is to provide a more standardized model for how companies report and recognize revenue to increase accuracy, transparency and comparability of financial reports.
Historically, revenue has been recognized differently by companies depending on industry, geographic location, and the financial reporting standards being followed – IFRS or US GAAP. This means that different accounting is being applied for transactions that are economically similar. In other words, the revenue recognition wheel is getting reinvented over and over again by companies everywhere. The Financial Accounting Standards Board (FASB) states on their Revenue Recognition project site that the objective of the updated standard is “…to establish the principles to report useful information to users of financial statements about the nature, amount, timing, and uncertainty of revenue from contracts with customers.”
This joint project by the FASB and International Accounting Standards Board (IASB) intends to get everybody on the same page when it comes to recognizing revenue and to develop a consistent revenue standard for US GAAP and IFRS that:
- Removes inconsistencies and weaknesses in existing revenue requirements.
- Provides a more robust framework for addressing revenue issues.
- Improves comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
- Provides more useful information to users of financial statements through improved disclosure requirements.
- Simplifies the preparation of financial statements by reducing the number of requirements to which an entity must refer.
The core principle of the update, as described by FASB, is “…to depict the transfer of goods or services to customers in amounts that reflect the consideration (that is, payment) to which the company expects to be entitled in exchange for those goods or services.”
Under the new guidance, companies will be required to follow these five steps when recognizing revenue from contracts with customers:
- Identify contract(s) with a customer.
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the separate performance obligations.
- Recognize revenue when the entity satisfies each performance obligation.
FASB was behind the original call to improve the revenue recognition standards back in 2002, but the IASB also recognized room for enhancement. As a result, the two standards issuers came together and produced the converged guidance as a joint pursuit.
The second part of the “who” in this equation concerns those that will be affected by the new revenue recognition guidance. It’s really quite simple, and FASB makes no bones about it about on the project site:
“The new guidance on revenue recognition affects any reporting organization that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts).”
In other words, everyone. Whether public or private, you’re expected to comply with the new standards – albeit at different times (but we’ll get to that in a later post).
The standards for revenue recognition under IFRS and US GAAP have been disparate entities for many years. This makes it difficult, if not nearly impossible, for consumers of financial reports to compare these documents across industries and geographic regions to use the data in a meaningful way. Additionally, the inconsistency and ambiguity around recognizing revenue creates a lot of confusion and headaches among reporting companies preparing financial statements.
In an increasingly borderless global economy, this kind of disarray on such a critical data point just isn’t practical. Much like the other most talked about financial reporting issue - XBRL in case you haven’t had your coffee today, - the aim is to create a uniform standard with a consistent methodology that all publicly traded companies can implement and follow. The revised standard is expected to have dual benefit for both creators and consumers of financial statements: The documents will be easier to prepare and easier to read and use in a meaningful way. It’s a win-win situation.
If you’re still not sold on why this update is a necessary improvement, consider that this one standard is replacing more than 200 specialized and/or industry-specific revenue recognition requirements under US GAAP.
The new standard will be followed in any country where companies adhere to the accounting standards issued by the IASB and/or FASB.
For public companies and some non-profit organizations, the revised revenue recognition standard will come into effect in financial reporting cycles after December 15, 2017. One thing to note is that this includes interim reporting periods within that reporting period.
For those that are ahead of the curve in terms of preparation for the standard, companies are more than welcome to apply the standard earlier, beginning after December 15, 2016.
For a more detailed timeline, stay tuned for the next post in our series: Revenue Recognition Standard: The Timeline, which will be posted next week.