New 5-Step Revenue Recognition Model: What does it all mean?

The 5-Step Model

While I was working with a customer last week, I realized they didn’t quite understand the new 5-step model for revenue recognition.  It’s not that the 5-steps were unknown, but rather the nuance associated which each step wasn’t crisp…how to make certain decisions wasn’t fully worked through.  Curious as to how pervasive this gap in understanding was, I began asking more conceptual questions of customers and I noticed this same scenario repeating itself.  With that in mind, I would like to walk through the 5-step process and some items to consider for each step.

Step 1: Identify the Contract(s) with the Customer

The first step is to identify if you have a contract (or contracts) with the customer.  A contract is an arrangement between two or more parties that creates enforceable rights and obligations.  To provide more clarity on what this means, the following items have been included as essential parts of a contract:

• All parties have approved the agreement
• All parties are committed to fulfilling their obligations
• All parties have identifiable rights
• The payment terms are identified
• The contract has commercial value
• The payment is likely to be received

There are a few other areas of importance when identifying the contract(s):

The Combination of Contracts:

When multiple contracts with the same customer exist, the vendor must combine them into one contract if they are entered into at or near the same time and one of the following is true: the contracts are negotiated as package with one business objective, the payment amount for one contract is dependent on the performance of the other, or at least some of the promised goods or services are a single performance obligation.

The Modification of Contracts:

The transaction price, the scope of the contract, or both may be changed by the parties to the contract.  This event may generate a new contract or a modification to the existing contract depending on the circumstances of the change which may alter the timing of the recognition of revenue.  A modification results in a separate contract if additional goods or services are included and the transaction price increases by a comparable amount to the standalone selling price.

Note: There are times when an agreement is in place, but it doesn’t qualify as a contract.  In this special case, revenue can be recognized when the agreement has been terminated or no more goods or services are owed and all of the transaction price has been received; both require that the payment is non-refundable.

Step 2: Identify the Performance Obligations in the Contract

The second step is to identify all of the performance obligations in the contract.  A performance obligation is defined as a promise to transfer a distinct good or service or a series of distinct goods or services which are substantially the same with the same pattern of transfer and the good(s) or service(s) can be explicitly stated in the contract or implied.  For a good or service to be distinct, it needs to be capable of being distinct (the customer can benefit from the good or service either on its own or as part of other resources readily available to the customer) or distinct within the context of the contract (the promise to transfer the good or service is separately identifiable from other promises in the contract).  If a good or service is not distinct, it should be combined with other goods or services until a distinct bundle is created.

There are several items to consider when determining the performance obligations in the contract.  A few of them are as follows:

Principal versus Agent:

Sometimes in the fulfilment of the performance obligation, other parties are required.  In this scenario, the entity has to determine if its performance obligation is to provide the good or service (acting as the principal) or to coordinate another party to provide the good or service (acting as the agent).  For a more detailed analysis of this, please see a blog posted by a colleague of mine titled FASB/IASB "Clarifies" Principal vs. Agent Handoffs for RevRec Purposes - What does this mean to you?

Warranties:

Often when you purchase something, it comes with a warranty.  The warranty can be either explicitly stated or implied.  The warranty either guarantees the good(s) or service(s) meets the promised specification or provides additional service(s) to the customer.  Assurance-type warranties include things like a promise to repair or replace something if it does not perform as expected and are not considered a separate performance obligation.  Service-type warranties are those that are purchased separately or provide service(s) beyond the guarantee of a working product and is a distinct performance obligation.

Non-refundable Upfront Fees:

If a contract has a stipulation to require the payment of an upfront fee, the entity must assess whether the fee applies to the transfer of a promised good or service.  If the fees do, then a distinct performance obligation is created.  If the fee relates to specific goods or services transferred to a customer, account for this as a promised good or service and recognize allocated revenue on the transfer of the good or service.  If the fee does not relate to specific goods or services transferred to the customer, account for this as an advanced payment on future goods or services.

Customer Options for Additional Goods or Services:

There are many contracts that offer customers the option for additional goods or services which become a distinct performance obligation if the option provides a material right to the customer that is more significant than any discount available outside of the contract.

Rights of Return:

When you buy something, typically you have the right to return what you have purchased.  The company is obligated to accept the returned product, but this does not create a distinct performance obligation.  Rather, this adds variability to the transaction price of the contract and should be considered when looking at variable consideration (which is discussed in Step 3 below).

Stand-Ready Obligations:

With New Year’s resolutions still in the forefront of everyone’s minds, the best example of a Stand-Ready Obligation is that of a gym membership.  The gym provides a service of standing ready to provide goods or services.  Let’s say you sign up for a one year gym membership to provide unlimited access to the gym’s facility.  You benefit from the gym’s service of making the equipment available to you and your use of the equipment doesn’t affect the remaining goods and services the gym has contracted to provide.  There are two main aspects to this type of performance obligation: how the customer receives the benefits and the nature of the entity’s performance.  This will help determine the method for the recognition of revenue (straight-line, input, output, etc.).

Step 3: Determine the Transaction Price

The third step is to determine the transaction price for all of the goods or services in the contract.  The transaction price is the amount of consideration (fixed, variable, or both) an entity expects to be entitled to for the goods or services in the contract.  The transaction price is allocated to the performance obligation(s) in the contract and are recognized when (or as) the performance obligation(s) are satisfied.

There are several items to consider when determining the transaction price for goods or services in the contract.  A few of them are as follows:

Variable Consideration:

If the promised amount of consideration in a contract is variable (subject to change due to timing, performance, or other factors), an entity would estimate the transaction price by using either the expected value (probability-weighted amount) or the most likely amount, depending on which method is a better indicator.  Variable consideration can come from a variety of sources including discounts, incentives, rebates, refunds, credits, and others.

Time Value of Money:

An entity would adjust the promised amount of consideration to reflect the time value of money if the contract has a financing component that is significant to the contract. Multiple factors should be considered when assessing if a financing component is significant to a contract.  For contracts where the entity expects (at contract inception) that the period between payment by the customer and the transfer of promised goods or services to the customer will not be satisfied within one year, the consideration would be adjusted to reflect the time value of money.

Noncash Consideration:

If a customer promises consideration in a form other than cash, the entity would measure the noncash consideration (or promise of noncash consideration) at fair value. If the entity cannot reasonably estimate the fair value of the noncash payment, it would measure it indirectly by reference to the standalone selling price of the goods or services promised to the customer in exchange for the consideration.

Step 4: Allocate the Transaction Price to the Performance Obligations

The fourth step is to allocate the transaction price to the performance obligations.  If a contract includes more than one performance obligation, the entity should allocate the total consideration to each performance obligation based on its relative standalone selling price.  If the standalone selling price is not observable, the entity must estimate the standalone selling price.  The standard does not prohibit any method for estimating the standalone selling price, as long as the estimation is an accurate representation of what price would be charged in a separate transaction.  However, the standard does call out three methods listed below:

Adjustment Market Assessment Method:

The adjusted market assessment method considers the market in which the good or services are sold.  Based on the market, the entity estimates what a customer of that market would be willing to pay.  This method is used primarily when competitors offer similar goods or services which would be used as the basis for the analysis and standalone selling price determination.

Expected Cost Plus Margin Method:

The expected cost plus margin method considers the forecasted costs associated with fulfilling the performance obligations and ads in the margin the market would be willing to pay.  This method would be used when the fulfilment costs are known and clearly identifiable or when the demand for the good or service is unknown.

Residual Method:

The residual method allows an entity to use observable standalone selling prices for one or more of its performance obligations to allocate the remaining transaction price to the performance obligations that do not have observable standalone selling prices.  The residual method can only be used if the entity sells the same good or service to multiple customers with high variability in price or the entity has not established a price for the good or service and the good or service has not been previously sold on a standalone basis.

Step 5: Recognize Revenue when (or as) the Performance Obligation is Satisfied

The fifth and final step is to recognize revenue when (or as) the performance obligation is satisfied.  An entity would recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is considered transferred when (or as) the customer gains control of that good or service.  The entity has to determine if the performance obligation is satisfied over time by transferring control of a good or service over time. If the entity does not satisfy a performance obligation over time, by default the performance obligation is satisfied at a point in time.

Some of the items to consider when recognizing revenue include:

Indicators of Transfer of Control:

In order for a performance obligation to be satisfied, a transfer of control must happen.  Control of an asset includes being able to prevent other entities from obtaining benefits from the asset.  To determine when control of the asset is transferred, many indicators must be considered.  The standard outlines five (5) indicators, but the list is not meant to be all-inclusive:

1. The entity has a present right to payment
2. The customer has a legal title to the asset
3. The entity has transferred physical possession of the asset
4. The customer has the significant risks and rewards of ownership of the asset
5. The customer has accepted the asset

Performance Obligations Satisfied Over Time:

According to the new standard, an entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met:

1. The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
2. The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
3. The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.

Call to Action

I hope you found this information helpful.  If there is anything that you would like to see that wasn’t presented, please do let me know in the comments section below or feel free to reach out to me directly.

If you would like to see the 5-Step Model in action, please join me for a webinar, titled SAP RAR 1.1 in Action, which will be held January 21st at 10:00 am PT.  Even if you do not use SAP, this webinar will be a good opportunity to see the process changes and how revenue streams get impacted.  You will see a live demo of the system as it walks through a scenario under the new standards.  To register for the event, take action and click here:

If you have any questions about the changes, Revenue Recognition, what to do, or would like to speak with me about something else, please feel free to reach out to me directly.  You can find me at larrym@bramasol.com or follow me on twitter @LarryTheSAPGuy.