In our first edition of this series we introduced the new Accounting Standard Update (ASU) No. 2014-09, Revenue from Contracts with Customers. This standard is specific and all-encompassing and the FASB (Financial Accounting Standards Board) provides framework for applying core principles of the standard to recognize the value of revenue from contracts and when it is to be recognized. Step One begins with the business identifying contracts it has with its customers.
ASU 2014-09 impacts companies in every industry that utilize contracts with patrons. In addition to outlining situations for when and how revenue needs to be recognized, it also reflects the consideration to which the entity expects to be entitled to for the exchange of goods or services. Basically stated: customers in contracts with a business are entitled to receive documentable revenue, and businesses are required to keep these documents. Both parties have a role to play, and the IRS is using the standard to guarantee that obligations are being fulfilled.
Step One: Contract Identification
ASC 606 states that a contract is defined as: an agreement between two or more parties that creates enforceable rights and obligations. These rights and obligations are legally binding, and contracts can be entered into agreement in several ways. Businesses should apply the requirements for the duration of the contract under these norms: 1) approval and commitment by each party, 2) identification of the rights of each party to the contract, 3) payment terms, and 4) ensuring that the contract has substantial commercial substance. Finally, it is probable that the entity will collect the consideration to which it will be entitled in exchange for goods/services. If the contract does not meet these criteria, the entity should continue to assess the contract until they are subsequently met.
Explanation for Contract Identification
When determining whether a contract exists or not, assessment guidelines have been given pertaining to combination contracts, modifications of contracts, and costs that go into obtaining or fulfilling a contract.
If two or more contracts are entered into at the same time with the same or related customer, the contract is treated as a single contract if negotiations have gone into place as a single commercial objective in the contract, the amount of consideration to be paid in one contract depends on the price/performance another contract, or goods/services promised in the contract is a single performance obligation.
Modifications exist when parties approve stipulations, thereby creating new, or changing existing, enforceable rights and obligations of the parties to the contract. These adaptations can translate into a separate contract if certain conditions are met, per the standard.
Obtaining or Fulfilling Costs
Businesses should recognize the incremental costs of obtaining a contract, as well as costs for fulfilling a contract.
Requirements and Criteria
Revenue is recognized when a customer obtains the stated objective (good/service). Minimum requirements must be in place to ensure recognition of revenue. First, businesses must have a customer agreement that meets the definition of a contract under the standard (see above definition). Secondly, the contract has specific revenue recognition criteria that must be applied:
- Parties must approve the contract and are committed to perform stated obligations.
- Entities must identify each party’s rights concerning transfer of goods/services.
- Entities must identify payment terms.
- Contract has commercial substance for transfer of goods/services.
- Entity may collect consideration to which it is entitled in exchange for goods/services.
Contracts that do not meet these five requirements can have repercussions on financial statements and existing contract practices with customers may need to be addressed.
Contact A CPA Today
Under the new standard, businesses will need to closely look into current contract provisions and details. Revisions to current contract language may need to be discussed with an accountant and/or an attorney, as contract enforceability is a legal determination. At Lawhorn CPA Group, we are diligently staying on top of changes in tax laws and regulations that affect our clients. Direction from an accountant regarding this standard and corresponding disclosures is available. Reach out today via our website or by calling us at 865-212-4867.