In May of 2014, the Financial Accounting Standards Board (FASB) unveiled new revenue recognition criteria in NJ and nationwide for contracts with customers. The old rule addressed this issue by having different standards based on the type of business. In order to simplify reporting methods, all industries will now use the same five-point-method to identify and recognize revenue.
Since many organization conduct business with contracts, the revised revenue recognition standard has a broad effect. While the updated rules do not go into effect until December 15, 2016, many organizations will require that entire time period to prepare for and implement the changes.
The updated revenue recognition criteria is broken down into a five step process that evaluates and ultimately recognizes revenue:
1. Identify the contract with a customer.
The first step in the updated process is to identify contracts with customers in your organizations. The updated revenue recognition criteria in NJ is applied to both written, verbal and implied contracts. This new standard applies once it is “probable” that the organization will receive revenue generated by a contract.
Whether a contract can be considered as probable to generate revenue is determined by the customer’s ability and intent to pay for the contracted goods or services.
Multiple contracts may be combined into one for accounting purposes if those contracts are enacted around the same time, as long as all of the contracts meet the new revenue recognition criteria in NJ. This consideration can simplify the recording process for revenue generation with a single customer.
With contracted jobs, particularly those of a large scale, changes are common and are often expected. For revenue recognition purposes, modified contracts may be considered as either a modification to the original contract or a new contract. The determination of the method of recording the revenue from modified contracts will depend on the particulars of that specific contract modification. Each modified contract must be evaluated independently.
2. Identify the performance obligations in the contract.
After an organization has identified a contract, that contract must be evaluated to determine the specific obligations outlined in the contract. For some contracts, particularly those for the exchange of goods and small-scale projects, this process may be simple. Large-scale projects and bundled services, such as those provided by telecommunications companies, will need to be closely evaluated.
The goal here is to identify the specific performance obligations that are identified in a contract. This is done by evaluating if goods or services provide a benefit when evaluated independently from the rest of the contract. Once these specific performance obligations are identified, they become the performance obligations for the contract. For the purpose of revenue recognition criteria in NJ, each of these obligations is evaluated separately.
There are some instances where a contract will only have a single performance obligation. This may be the case where goods are sold under contract or when services are provided to the customer in the same manner. An example of this could be labor done for an hourly wage by a tradesperson on a job. Even if the job takes multiple days to complete, there may be only one performance obligation depending on how the contract is written and how the customer benefits from the service.
3. Determine the price of the transaction.
At first glance, determining the price of a transaction seems simple. However, that may not always be the case. In order to determine the price of a transaction, several points must be considered:
- Variables – If a contract includes bonuses or incentives, those items must be evaluated to determine the probability that they will occur in order to arrive at an anticipated total price. This calculation must be based in fact and must consider the likelihood of the variable income to be paid.
- Time Value of Money – For long term contracts or contracts that utilize financing, the time value of money must be considered in order to arrive at the true price of a contract.
- Non-Cash Payment – If payment for a contract is being provided in goods or services rather than in cash, the organization must take steps to quantify the market value for the anticipated payment.
- Coupons and Discounts – If the price of a contract is reduced by the use of coupons or other discount method, the effect of these items must be considered when determining price.
4. Allocate the transaction price to the obligations in the contract.
Once the contract has been divided into performance obligations and the price is determined, the price must be allocated across the performance obligations in the contract. The objective is to give a selling price for each of the obligations outlined in the contract.
When an organization is determining what price should be allocated to each obligation, they must first determine the price for each item on its own. If an organization always offers a good or service on its own, this process may be simple. If a good or service is not available on its own, the organization must use reasonable practices to allocate the transaction price to the contracted obligations.
5. Recognize revenue when performance obligations are complete.
Revenue recognition criteria in NJ now indicates revenue may be recorded only when an obligation is fulfilled under the contract. Revenue may only be recognized when an exchange of goods has taken place or the requested services have been fulfilled. This may be done in time with the transfer of goods or services or over time, depending on the contracted specifics.
How revenue is recognized is completely dependent on when obligations are complete, not with payment for those obligations. The time period for recognizing revenue and receiving payment for said revenue may not be closely aligned. Because of this, organizations may need to reconsider how company and employee performance is evaluated.
The changes required by the updated revenue recognition criteria in NJ are complex . As such, they should be handled by qualified accounting professionals.
