Collaborating Author: Tracy Abruzzo
Has your CFO been talking about something called revenue recognition that's supposed to go live next year? It’s a completely new five-step model that replaces over 150 pieces of existing guidance on how to recognize revenue and consistently applies the same approach across industries – so no more specialized industry rules.
The five-step model is as follows:
- Identify the contract with the customer
- Identify the performance obligations
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognize revenue when (or as) performance obligations are satisfied
In many ways, this new revenue recognition model simplifies the accounting. However, there are a few areas that are likely to provide challenges to your entire organization, even the IT team. Those areas are variable consideration, contract modifications and enhanced disclosures.
What’s variable consideration? Basically, variable consideration is any consideration that is not fixed or is contingent upon the outcome of some future event such as refunds, credits, incentives, performance bonuses or penalties, royalties, price concessions, rights of return, etc. These amounts must now be estimated and included in the transaction price that is allocated among the performance obligations (a good or service that is distinct) within the contract. A simple example is a situation where a contract for services provides for a fixed fee per month of $10,000 plus an additional variable amount based on 5% of the entity’s sales volume. That 5% of the entity’s sales volume is variable consideration, which must be estimated up front and continually adjusted for changes going forward.
Historically, there was limited guidance on how to handle a contract modification. A contract modification occurs when the parties to an existing contract agree to a change in price or in scope (or both). Now, there are comprehensive principles to apply in determining how to handle a contract modification. The modification may now need to be accounted for as a separate contract, as a termination of the existing contract and creation of a new contract, as part of the original contract or as a combination of these methods. You will need to be able to link the existing contract with the modification to determine how to recognize revenue going forward; revenue previously recognized may need to be reversed. It gets complicated quickly.
The changes in how companies handle variable consideration and contract modifications will require software models to capture additional information and perform more complex calculations with greater frequency. Even if you have an automated system and process now for recognizing revenue, you will likely need some enhancements to handle continual changes to transaction prices where variable consideration is present and re-calculations of the allocation of that transaction price to those revenue streams to specific performance obligations, not to mention reversing previously recognized revenue or recognizing more revenue in current periods. These calculations can be performed manually for a limited number of contracts, but as the volume of contracts with customers expand, the need for an automated solution increases exponentially.
So, even if you haven’t been impacted thus far, you will be by the significantly expanded disclosure requirements. Disclosures must contain enough depth for users to understand the nature, amount timing and uncertainty of revenue and cash flows arising from contracts with customers. Some of the key additional disclosures are:
- Disaggregation of revenue: to illustrate how the nature, amount, timing and uncertainty of cash flows are impacted by economic factors.
- Separately present and disclose contract assets, contract liabilities, contract costs and contract receivables: to illustrate the relationship between revenue recognized and the changes in the overall balances of these assets and liabilities.
- Status of performance obligations: to illustrate the amount to be recognized from unsatisfied performance obligations and when those amounts are expected to be recognized, etc.
So, your technology group probably should care about revenue recognition. This new revenue model must be applied to every type of contract, and it’s likely there will be some changes in how your organization recognizes revenue. Plus, you may have to revise previously recognized revenue amounts if there is a contract modification or changes in your company’s estimates of variable consideration. You will need more data, more analysis and judgment, possibly system upgrades and changes to processes and controls. At a minimum, there will be significantly expanded reporting and disclosures that will require additional data and controls and possibly new software modeling solutions to meet these new requirements. It’s time to get started.