Under the new standard for revenue recognition, the first step is identifying a contract with a customer. There needs to be a deal in place, under which goods and services will be exchanged for consideration. A contract is considered to exist when all of these criteria are met:
- The parties involved have approved the contract, in writing or orally, and are committed to performing their obligations.
- You can identify each party’s rights – what each organization will be giving and receiving.
- You can identify the payment terms for the goods or services being provided.
- The contract has commercial substance, meaning it will have an impact on your future cash flows.
- It is probable that you’ll collect what you are owed for the goods and services you’re providing.
Once a contract exists, the next step is identifying the performance obligations in it. A performance obligation is a distinct good or service, or bundle of goods or services, that you will deliver to your customer. A performance obligation is distinct if the customer can use it on its own, or with other resources that are readily available. If it is dependent on, or interrelated with, other items in the contract, you should combine them into a single obligation. An example of a good or service not being distinct would be if you’re integrating it with something else in the contract, and the integration needs to be complete for the item to have value to the customer. Individual parts to a table aren’t valuable unless you proceed to build the table, so the table as a whole would be a distinct performance obligation.
Next, what is the transaction price? That is, what will you be receiving in exchange for the goods and services you are providing? There are a few factors to take into consideration when you’re putting a value on it:
- Variable Consideration: Factor in discounts, rebates, refunds, incentives, performance bonuses, etc., that you’ll provide to the customer. Take into account historical practices for contracts you’ve already worked on, and anything specific to the current contract. In addition to what’s explicitly stated in the contract, make adjustments if the customer can reasonably expect you to adjust the price based on your usual business practices or policies.
- Constraining Estimates of Variable Consideration: You should only adjust the transaction price based on variable consideration if the variation occurring is probable. Are there any events that would impact the transaction price, even if it’s out of your control, such as weather conditions or market volatility? Have you offered discounts on similar contracts in the past, and how much? Is there uncertainty in the amount of consideration you’ll receive?
- Significant Financing Component: When will your customer be paying you? If you expect payment more than a year after you provide the goods and services, you should adjust your revenue for the time value of money.
- Noncash Consideration: If your customer will be paying you in a form other than cash, you should measure what you receive at fair value.
- Consideration Payable to a Customer: Revenue should be reduced if you will owe anything to the customer, other than the goods or services you are contracting for. If you are paying for a distinct good or service that the customer is providing to you, this is not a reduction of your revenue. You should account for it the same way you account for other purchases from suppliers.
The final steps will be allocating the transaction price among the performance obligations in the contract, and recognizing the revenue when or as you meet those obligations. There are also disclosures to include in your financial statements. I’ll cover all of these details in an upcoming post.