For several years the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have worked to develop a single standard revenue recognition model. This new standard will apply to all industries and companies using either the U.S. GAAP and IFRS accounting standards. The intention of the new revenue recognition model is to improve financial statements and eliminate differences between GAAP and IFRS.

In November the FASB and IASB voted to move forward with preparation of the final standard which is expected to be issued in the first quarter of 2014. What does this mean to you and your organization?

This new standard on revenue recognition is a principles-based approach (with some guidance) rather than a “bright line” rules-based approach. It will be a single revenue recognition model applied across all industries and transactions. When the new standard becomes effective, industry-specific revenue recognition accounting will no longer exist. This is a significant change.

At the time of this writing, the proposed effective date for publicly held entities with annual reporting periods beginning on or after December 15, 2016 (with no early adoption) and for privately held entities with annual reporting periods beginning on or after December 15, 2017, with early adoption allowed but no sooner than December 15, 2016.

The core principle is that “an entity must recognize revenue when it transfers promised goods and services to the customer and the amount recognized should be the consideration to which the entity expects to be entitled.”[1] Businesses will determine the correct revenue recognition using this Five Step Model:

1. Identify the contract(s)
2. Identify the separate performance obligations
3. Determine the transaction price
4. Allocate the transaction price to the separate performance obligations
5. Recognize revenue when the entity satisfies a performance obligation

The Five Step Model appears manageable, but let’s look more closely at each step.

Step 1: Identify the contract

A fairly straightforward step whereby specific criteria must be met in order to have a contract. Specifically, the contract must have commercial substance, the promised goods and services must be identified and approved, and the payment terms identified.

Step 2: Identify separate performance obligations

This is applicable when an entity transfers more than one good or service to the customer and the additional good or service is distinct. In order for a good and service to be distinct it could be sold separately or the customer can benefit from the good or service either on its own or together with readily available resources. However a good or service is not distinct if it’s bundled with other goods and services; if the business services are highly interrelated; and if the goods and services are significantly modified or customized.[2] As an example, if you sold a car with a 5-year warranty included in the purchase price and sold a separate three-year extended warranty.  The three-year extended warranty would be a separate performance obligation.

 Step 3:  Determine the transaction price

According to the new revenue recognition model, the transaction price “is the amount of consideration to which the entity expects to receive for the transfer of the promised goods and services.”[3] In determining the transaction price, management will need to take into consideration the variable consideration, time, value of money, non-cash consideration, and consideration payable to the customer.

The determination of variable consideration will require significant amount of judgment. Variable consideration includes items such as discounts, rebates, refunds, and royalties. In estimating the transaction price the entity would use either the expected value method or the most likely amount method.  I will state the obvious here, but both of these methods require management’s best guess. In addition, for an entity to estimate the variable consideration the entity must have relevant experience with the item and the probability of significant reversals would not occur.

Step 4: Allocate the transaction price to the separate performance obligations

A business determines this based upon the relative standalone-selling price of each performance obligations. In determining the standalone-selling price, management needs to identify observable evidence. If none exist management will need to use a method of estimation to determine the standalone-selling price. Once this has been determined they allocate the amount of consideration expected to each of the separate performance obligations.

 Step 5: Recognize revenue when the entity satisfies a performance obligation

This is accomplished when the customer obtains control of the good or service. If the performance obligation is satisfied over time (construction of an asset), and there exists continuous improvement of the asset, the entity would use a progress method (output or input method) to recognize revenue. The percent of completion method would not be used during the step.

The new model requires that management make more estimates and judgments in areas of identifying separate performance obligations, determining the transaction price, variable consideration, the allocation of the transaction price, and when control has been transferred. This increase in estimates and judgments mean that management should assess and update internal controls and processes to avoid fraud.

Additionally, management will need to forecast revenue changes to determine any significant changes in the financial metrics in order to avoid any covenant violations. These changes in forecasted revenue should also be analyzed for any potential tax planning opportunities when the standard becomes effective.

What does this mean for your organization? Entities will be required to show two-year comparative data, either on the face or in the notes to the final statements, when they file their 2017 financial statements. In other words, you will need to be ready by the end of 2015.

It’s time to start planning.