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Why Is the FASB Issuing This Accounting Standards Update (Update)?

Revenue is an important number to users of financial statements in assessing an entity’s financial performance and position. However, previous revenue recognition requirements in U.S. generally accepted accounting principles (GAAP) differ from those in International Financial Reporting Standards (IFRS), and both sets of requirements were in need of improvement. Previous revenue recognition guidance in U.S. GAAP comprised broad revenue recognition concepts together with numerous revenue requirements for particular industries or transactions, which sometimes resulted in different accounting for economically similar transactions. In contrast, IFRS provided limited guidance and, consequently, the two main revenue recognition standards, IAS 18, Revenue, and IAS 11, Construction Contracts, could be difficult to apply to complex transactions. Additionally, IAS 18 provides limited guidance on important revenue topics such as accounting for multiple-element arrangements.
Accordingly, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRS that would:
  1. Remove inconsistencies and weaknesses in revenue requirements.
  2. Provide a more robust framework for addressing revenue issues.
  3. Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
  4. Provide more useful information to users of financial statements through improved disclosure requirements.
  5. Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.
To meet those objectives, the FASB is amending the FASB Accounting Standards Codification® and creating a new Topic 606, Revenue from Contracts with Customers, and the IASB is issuing IFRS 15, Revenue from Contracts with Customers. The issuance of these documents completes the joint effort by the FASB and the IASB to meet those objectives and improve financial reporting by creating common revenue recognition guidance for U.S. GAAP and IFRS.

Who Is Affected by the Amendments in This Update?

The guidance in this Update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts).
The guidance in this Update supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance throughout the Industry Topics of the Codification. Additionally, this Update supersedes some cost guidance included in Subtopic 605-35, Revenue Recognition—Construction-Type and Production-Type Contracts.
In addition, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer (for example, assets within the scope of Topic 360, Property, Plant, and Equipment, and intangible assets within the scope of Topic 350, Intangibles—Goodwill and Other) are amended to be consistent with the guidance on recognition and measurement (including the constraint on revenue) in this Update.

What Are the Main Provisions?

The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
To achieve that core principle, an entity should apply the following steps:
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

Step 1: Identify the Contract with a Customer

A contract is an agreement between two or more parties that creates enforceable rights and obligations. An entity should apply the requirements to each contract that meets the following criteria:
  1. Approval and commitment of the parties
  2. Identification of the rights of the parties
  3. Identification of the payment terms
  4. The contract has commercial substance
  5. It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
In some cases, an entity should combine contracts and account for them as one contract. In addition, there is guidance on the accounting for contract modifications.

Step 2: Identify the Performance Obligations in the Contract

A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. If an entity promises in a contract to transfer more than one good or service to the customer, the entity should account for each promised good or service as a performance obligation only if it is (1) distinct or (2) a series of distinct goods or services that are substantially the same and have the same pattern of transfer.
A good or service is distinct if both of the following criteria are met:
  1. Capable of being distinct—The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.
  2. Distinct within the context of the contract—The promise to transfer the good or service is separately identifiable from other promises in the contract.
A good or service that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct.

Step 3: Determine the Transaction Price

The transaction price is the amount of consideration (for example, payment) to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. To determine the transaction price, an entity should consider the effects of:
  1. Variable consideration—If the amount of consideration in a contract is variable, an entity should determine the amount to include in the transaction price by estimating either the expected value (that is, probability-weighted amount) or the most likely amount, depending on which method the entity expects to better predict the amount of consideration to which the entity will be entitled.
  2. Constraining estimates of variable consideration—An entity should include in the transaction price some or all of an estimate of variable consideration only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
  3. The existence of a significant financing component—An entity should adjust the promised amount of consideration for the effects of the time value of money if the timing of the payments agreed upon by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing for the transfer of goods or services to the customer. In assessing whether a financing component exists and is significant to a contract, an entity should consider various factors. As a practical expedient, an entity need not assess whether a contract has a significant financing component if the entity expects at contract inception that the period between payment by the customer and the transfer of the promised goods or services to the customer will be one year or less.
  4. Noncash consideration—If a customer promises consideration in a form other than cash, an entity should measure the noncash consideration (or promise of noncash consideration) at fair value. If an entity cannot reasonably estimate the fair value of the noncash consideration, it should measure the consideration indirectly by reference to the standalone selling price of the goods or services promised in exchange for the consideration. If the noncash consideration is variable, an entity should consider the guidance on constraining estimates of variable consideration.
  5. Consideration payable to the customer—If an entity pays, or expects to pay, consideration to a customer (or to other parties that purchase the entity’s goods or services from the customer) in the form of cash or items (for example, credit, a coupon, or a voucher) that the customer can apply against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer), the entity should account for the payment (or expectation of payment) as a reduction of the transaction price or as a payment for a distinct good or service (or both). If the consideration payable to a customer is a variable amount and accounted for as a reduction in the transaction price, an entity should consider the guidance on constraining estimates of variable consideration.

Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract

For a contract that has more than one performance obligation, an entity should allocate the transaction price to each performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each performance obligation.
To allocate an appropriate amount of consideration to each performance obligation, an entity must determine the standalone selling price at contract inception of the distinct goods or services underlying each performance obligation and would typically allocate the transaction price on a relative standalone selling price basis. If a standalone selling price is not observable, an entity must estimate it. Sometimes, the transaction price includes a discount or variable consideration that relates entirely to one of the performance obligations in a contract. The requirements specify when an entity should allocate the discount or variable consideration to one (or some) performance obligation(s) rather than to all performance obligations in the contract.
An entity should allocate to the performance obligations in the contract any subsequent changes in the transaction price on the same basis as at contract inception. Amounts allocated to a satisfied performance obligation should be recognized as revenue, or as a reduction of revenue, in the period in which the transaction price changes.

Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation

An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when (or as) the customer obtains control of that good or service.
For each performance obligation, an entity should determine whether the entity satisfies the performance obligation over time by transferring control of a good or service over time. If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.
An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time if one of the following criteria is met:
  1. The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
  2. The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
  3. The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a point in time. To determine the point in time at which a customer obtains control of a promised asset and an entity satisfies a performance obligation, the entity would consider indicators of the transfer of control, which include, but are not limited to, the following:
  1. The entity has a present right to payment for the asset.
  2. The customer has legal title to the asset.
  3. The entity has transferred physical possession of the asset.
  4. The customer has the significant risks and rewards of ownership of the asset.
  5. The customer has accepted the asset.
For each performance obligation that an entity satisfies over time, an entity shall recognize revenue over time by consistently applying a method of measuring the progress toward complete satisfaction of that performance obligation. Appropriate methods of measuring progress include output methods and input methods. As circumstances change over time, an entity should update its measure of progress to depict the entity’s performance completed to date.

Costs to Obtain or Fulfill a Contract with a Customer

The guidance also specifies the accounting for some costs to obtain or fulfill a contract with a customer.
Incremental costs of obtaining a contract—An entity should recognize as an asset the incremental costs of obtaining a contract that the entity expects to recover. Incremental costs are those costs that the entity would not have incurred if the contract had not been obtained. As a practical expedient, an entity may expense these costs when incurred if the amortization period is one year or less.
Costs to fulfill a contract—To account for the costs of fulfilling a contract with a customer, an entity should apply the requirements of other standards (for example, Topic 330, Inventory; Subtopic 350-40; Internal-Use Software; Topic 360, Property, Plant, and Equipment; and Subtopic 985-20, Costs of Software to Be Sold, Leased, or Marketed), if applicable. Otherwise, an entity should recognize an asset from the costs to fulfill a contract if those costs meet all of the following criteria:
  1. Relate directly to a contract (or a specific anticipated contract)
  2. Generate or enhance resources of the entity that will be used in satisfying performance obligations in the future
  3. Are expected to be recovered.

Disclosures

An entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Qualitative and quantitative information is required about:
  1. Contracts with customers—including revenue and impairments recognized, disaggregation of revenue, and information about contract balances and performance obligations (including the transaction price allocated to the remaining performance obligations)
  2. Significant judgments and changes in judgments—determining the timing of satisfaction of performance obligations (over time or at a point in time), and determining the transaction price and amounts allocated to performance obligations
  3. Assets recognized from the costs to obtain or fulfill a contract.

How Do the Main Provisions Differ from Current U.S. Generally Accepted Accounting Principles (GAAP) and Why Are They an Improvement?

In setting the project objectives, the Board observed that revenue is commonly viewed as a critical number to users of financial statements in assessing an entity’s financial performance and position. Additionally, the Board noted that revenue recognition requirements in U.S. GAAP differ from those in IFRS. The introduction of a comprehensive and converged standard on revenue recognition will enable users to better understand and consistently analyze an entity’s revenue across industries, transactions, and geographies.
The guidance on revenue recognition in U.S. GAAP was initially limited to the general guidance in Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. Concepts Statement 5 specifies that an entity should recognize revenue only when realized or realizable and earned. Those recognition and measurement concepts were codified in Subtopic 605-10, Revenue Recognition–Overall. Additionally, FASB Concepts Statement No. 6, Elements of Financial Statements, defines revenues as inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
In 1999, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition, which provides interpretive guidance on how a public entity should apply the realized or realizable and earned criteria in Concepts Statement 5 to arrangements not within the scope of other, specific authoritative literature on revenue recognition. SAB 101 (amended in 2003 by SAB No. 104, Revenue Recognition, and codified into SAB Topic 13), requires an entity to satisfy specific criteria before recognizing revenue. Nonpublic entities are not subject to this guidance; however, the Board understands that some apply it in practice by analogy.
Additional guidance for recognizing revenue in U.S. GAAP consists of numerous industry-specific and transaction-specific standards (for example, Subtopic 985-605, Software—Revenue Recognition, Subtopic 605-35, Revenue Recognition—Construction-Type and Production-Type Contracts, Subtopic 360-20, Property, Plant, and Equipment—Real Estate Sales, and Subtopic 605-25, Revenue Recognition—Multiple-Element Arrangements). Those requirements were developed by various standard setters often to address narrow issues or transactions without reference to a common framework. Consequently, issues about recognizing revenue were often difficult to resolve, and economically similar transactions sometimes yielded differing revenue recognition.
The guidance for recognizing revenue in IFRS was comparatively limited and was based on different fundamental principles. IFRS lacked guidance on particular topics that were challenging to address in practice (for example, multiple-element arrangements). Consequently, the guidance for recognizing revenue under IFRS was difficult to apply to many complex transactions, and many times in the absence of specific guidance an entity may use, or analogize, to U.S. GAAP.
Under current U.S. GAAP, the required disclosures about revenue were limited and lacked cohesion. General disclosure requirements about revenue recognition were limited to descriptions of an entity’s related accounting policies and the effect on revenue of those policies, including rights of return, the entity’s role as a principal or an agent, and customer payments and incentives. Some industry-specific or transaction-specific revenue recognition guidance required more extensive disclosures; however, investors and other users of financial statements indicated that the previous disclosure requirements about revenue in both U.S. GAAP and IFRS were insufficient for analyzing an entity’s revenue.
The Board considered the existing guidance on revenue recognition and concluded that the new revenue recognition guidance in this Update will provide an improvement to financial reporting.
As compared to existing guidance on revenue recognition, this Update will significantly enhance comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets. The largely principles-based guidance in this Update provides a framework for addressing revenue recognition issues comprehensively for entities that apply U.S. GAAP in addition to those entities that apply IFRS. Because the guidance in this Update is principles-based, it can be applied to all contracts with customers regardless of industry-specific or transaction-specific fact patterns. Additionally, the Board concluded that a framework for revenue recognition best ensures that the guidance remains relevant as markets and transactions evolve.
The guidance in this Update also improves U.S. GAAP by reducing the number of requirements to which an entity must consider in recognizing revenue. For example, before this Update an entity would have potentially considered industry-specific revenue guidance for some transactions, in addition to general revenue guidance and potentially other relevant guidance that commonly affects revenue transactions. Rather than referring to several locations for guidance, this Update provides a comprehensive framework within Topic 606. As a result of issuing this Update, the Board concluded that over time the guidance for recognizing revenue in U.S. GAAP should be less complex than current guidance.
Additionally, the guidance requires improved disclosures to help users of financial statements better understand the nature, amount, timing, and uncertainty of revenue that is recognized. The comprehensive disclosure package will improve the understandability of revenue, which is a critical part of the analysis of an entity’s performance and prospects. Furthermore, this Update provides guidance for transactions that are not addressed comprehensively (for example, service revenue, contract modifications, and licenses of intellectual property). Finally, the guidance will apply to all entities, including nonpublic entities that previously did not have extensive guidance.

When Will the Amendments Be Effective?

For a public entity, the amendments in this Update are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted.
A public entity is an entity that is any one of the following:
  1. A public business entity
  2. A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an overthe-counter market
  3. An employee benefit plan that files or furnishes financial statements to the SEC.
For all other entities (nonpublic entities), the amendments in this Update are effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. A nonpublic entity may elect to apply this guidance earlier, however, only as of the following:
  1. An annual reporting period beginning after December 15, 2016, including interim periods within that reporting period (public entity effective date)
  2. An annual reporting period beginning after December 15, 2016, and interim periods within annual periods beginning after December 15, 2017
  3. An annual reporting period beginning after December 15, 2017, including interim periods within that reporting period.
An entity should apply the amendments in this Update using one of the following two methods:
1. Retrospectively to each prior reporting period presented and the entity may elect any of the following practical expedients:
a. For completed contracts, an entity need not restate contracts that begin and end within the same annual reporting period.
b. For completed contracts that have variable consideration, an entity may use the transaction price at the date the contract was completed rather than estimating variable consideration amounts in the comparative reporting periods.
c. For all reporting periods presented before the date of initial application, an entity need not disclose the amount of the transaction price allocated to remaining performance obligations and an explanation of when the entity expects to recognize that amount as revenue.
2. Retrospectively with the cumulative effect of initially applying this Update recognized at the date of initial application. If an entity elects this transition method it also should provide the additional disclosures in reporting periods that include the date of initial application of:
a. The amount by which each financial statement line item is affected in the current reporting period by the application of this Update as compared to the guidance that was in effect before the change.
b. An explanation of the reasons for significant changes.

How Do the Provisions Compare with International Financial Reporting Standards (IFRS)?

This Update, together with the IASB’s IFRS 15, completes a joint effort by the FASB and the IASB to improve financial reporting by creating common revenue recognition guidance for U.S. GAAP and IFRS that clarifies the principles for recognizing revenue and that can be applied consistently across various transactions, industries, and capital markets. In this Update and IFRS 15, the Boards achieved their goal of reaching the same conclusions on all requirements for the accounting for revenue from contracts with customers. However, there are some minor differences as follows:
  1. Collectibility threshold—The Boards included an explicit collectibility threshold as one of the criteria that a contract must meet before an entity can recognize revenue. For a contract to meet that criterion, an entity must conclude that it is probable that it will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. In setting the threshold, the Boards acknowledged that the term probable has different meanings in U.S. GAAP and IFRS. However, the Boards decided to set the threshold at a level that is consistent with previous revenue recognition practices and requirements in U.S. GAAP and IFRS.
  2. Interim disclosure requirements—The Boards noted that the general guidance in their respective interim reporting guidance (Topic 270, Interim Reporting, and IAS 34, Interim Financial Reporting) would apply to revenue from contracts with customers. However, the IASB decided to also amend IAS 34 to specifically require the disclosure of disaggregated information of revenue from contracts with customers in interim financial statements. The FASB similarly decided to amend Topic 270 to require a public entity to disclose disaggregated revenue information in interim financial statements, but also made amendments to require information about both contract balances and remaining performance obligations to be disclosed on an interim basis.
  3. Early application and effective date—The guidance in this Update prohibits an entity from applying the requirements earlier than the effective date, whereas IFRS 15 allows an entity to apply the requirements early. Nonpublic entities may apply the requirements earlier than the nonpublic effective date but no earlier than the public entity effective date. In addition, the effective date for IFRS 15 is for annual reporting periods beginning on or after January 1, 2017, whereas Topic 606 has an effective date for public entities for annual reporting periods beginning after December 15, 2016.
  4. Impairment loss reversal—Consistent with other areas of U.S. GAAP, the amendments in this Update do not allow an entity to reverse an impairment loss on an asset that is recognized in accordance with the guidance on costs to obtain or fulfill a contract. In contrast, IFRS 15 requires an entity to reverse impairment losses, which is consistent with the requirements on the impairment of assets within the scope of IAS 36, Impairment of Assets.
  5. Nonpublic entity requirements—This Update applies to nonpublic entities and includes some specific reliefs relating to disclosure, transition, and effective date. No such guidance is included within IFRS 15. IFRS for Small and Medium-sized Entities is available for entities that do not have public accountability.

Copyright #year# by Financial Accounting Foundation, Norwalk, Connecticut.

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