January 31, 2014
By David Katz, CPA
Revenue remains the driving force of businesses and a critical measurement point for start-ups and long-running companies alike. With the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) expected to release their converged revenue recognition standard in the first quarter of 2014, it is imperative that companies continue to monitor their revenue recognition policies to ensure consistency with applicable guidance. For now, U.S. companies must adhere to FASB Accounting Standards Codification (ASC) 605, “Revenue Recognition.”
In general, four criteria must be met to recognize revenue:
- Persuasive evidence that an agreement exists.
The existence of an agreement remains important as it specifies the nature and terms, which drives proper accounting treatment. For instance, a change in terms that changes the return policy could have a substantial impact on whether revenue could be recognized.
- Delivery has occurred or services have been rendered.
Typically, unless delivery has occurred or services have been rendered, the seller has not substantially completed its obligations. Delivery is generally deemed to have occurred when the customer assumes the risk and rewards of ownership. Until the obligation has been complete, revenue would not be recognized.
- The seller’s price is fixed and determinable.
The agreement typically specifies payment terms and factors into whether the price is fixed and determinable. Terms that may allow for refund or adjustment would not meet this criteria, and a company would need to consider whether revenue recognition is appropriate until refund or adjustment periods lapse.
- Collectability is reasonably assured.
Revenue is considered realizable when related assets received are readily convertible to cash or claims to cash. If collectability is not reasonably assured, a company would not meet such criteria and thus would not be able to recognize revenue.
The guidance has separate sections for product (FASB ASC 605-15) and service revenue (FASB ASC 605-20), with specific examples due to varying related terms and circumstances.
Multiple element arrangements
FASB ASC 605-25 also lays out guidance for multiple element arrangements, which applies to all deliverables within most binding arrangements where a company performs multiple revenue-generating activities. Under the guidance, in an arrangement with multiple deliverables, the company must determine the units of account and whether the arrangement should be divided into separate units of accounting, as well as measurement and allocation of the consideration among those units. A delivered item shall be considered a separate unit if both 1) the item has stand-alone value to the customer (which does not require the existence of an observable market for the deliverable) and 2) there is a general right of return on the delivered item, delivery or performance of the undelivered item is considered probable and in control of the company. A delivered item or items that do not qualify as a separate unit of accounting within the arrangement shall be combined with the other applicable undelivered items within the arrangement. The allocation of arrangement consideration and the recognition of revenue then shall be determined for those combined deliverables as a single unit of accounting.
In determining amounts to recognize under multiple element arrangements, in most circumstances consideration is allocated at the inception of the arrangement to all deliverables on the basis of their relative selling price. When applying the relative selling price method, the selling price for each deliverable shall be determined using vendor-specific objective evidence of selling price, if it exists; otherwise, third-party evidence of selling price. If neither vendor-specific objective evidence nor third-party evidence of selling price exists for a deliverable, the vendor shall use its best estimate of the selling price for that deliverable. In deciding whether the vendor can determine vendor-specific objective evidence or third-party evidence of selling price, the vendor shall not ignore information that is reasonably available without undue cost and effort.
Revenue recognition by industry
FASB ASC 605 includes sections for various industries, including but not limited to software, airline, entertainment and health care. The guidance uses examples and illustrations to fit different circumstances in these industries, beyond the general rules above.
Overall, with a constantly evolving marketplace and accounting guidance changes, it remains essential for companies to continue revisiting their revenue recognition policies. As a slight change in an arrangement may trigger different revenue recognition, companies should evaluate contracts and arrangements consistently.