The new revenue recognition standards under GAAP (Accounting Standards Update 2014-09; Topic 606) will be applicable to public companies for annual reporting periods beginning after December 15, 2017. While much time and effort is being put into adoption of the new standard, consideration should also be given to how contracts can be drafted to facilitate revenue recognition under the new standard. While it is impossible to summarize every nuance that should be considered when preparing contracts, high level thoughts can be set forth on each of the five steps outlined in the new standard.
Identify the Contract(s)
The first step under the new standard it so identify the applicable contract. In general, the new standard provides that a contract is an agreement between two or more parties that creates enforceable rights and obligations. Lawyers should be aware an entity must combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account for the contracts as a single contract if one or more of the following criteria are met:
- The contracts are negotiated as a package with a single commercial objective.
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
- The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation.
Identify the Performance Obligations
The next step is to identify the performance obligations in the contract. A performance obligation is a promise in a contract with a customer to transfer to the customer either:
- A good or service (or a bundle of goods or services) that is distinct.
- A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
A good or service that is promised to a customer is distinct if both of the following criteria are met:
- 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 (that is, the good or service is capable of being distinct).
- The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the good or service is distinct within the context of 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.
The step is important because revenue is ultimately recognized when or as performance obligations are satisfied. Thus contract drafting principles should include clearly identifying the performance obligations to determine when revenue is recognized. The following example drives the point home:
An entity, a contractor, enters into a contract to build a hospital for a customer. The entity is responsible for the overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing.
The promised goods and services are capable of being distinct. The customer could benefit from the goods and services either on their own or together with other readily available resources. This is evidenced by the fact that the entity, or competitors of the entity, regularly sells many of these goods and services separately to other customers. In addition, the customer could generate economic benefit from the individual goods and services by using, consuming, selling, or holding those goods or services.
However, the way the contract is drafted, the goods and services are not distinct. The entity’s promise to transfer individual goods and services in the contract are not separately identifiable from other promises in the contract. This is evidenced by the fact that the entity provides a significant service of integrating the goods and services (the inputs) into the hospital (the combined output) for which the customer has contracted.
If business needs so dictated, the contract could have been drafted to arrive at a different result.
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. While ultimately there are other factors to consider, such as the existence of a financing component or non-cash consideration, generally an entity will have to consider the effects of:
- 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.
- 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.
The amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items. The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.
Consider the following example:
An entity enters into a contract with a customer to build a customized asset. The promise to transfer the asset is a performance obligation that is satisfied over time. The promised consideration is $2.5 million, but that amount will be reduced or increased depending on the timing of completion of the asset. Specifically, for each day after March 31, 20X7 that the asset is incomplete, the promised consideration is reduced by $10,000. For each day before March 31, 20X7 that the asset is complete, the promised consideration increases by $10,000.
In addition, upon completion of the asset, a third party will inspect the asset and assign a rating based on metrics that are defined in the contract. If the asset receives a specified rating, the entity will be entitled to an incentive bonus of $150,000.
In determining the transaction price, the entity prepares a separate estimate for each element of variable consideration to which the entity will be entitled:
The entity decides to use the expected value method to estimate the variable consideration associated with the daily penalty or incentive (that is, $2.5 million, plus or minus $10,000 per day). This is because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.
The entity decides to use the most likely amount to estimate the variable consideration associated with the incentive bonus. This is because there are only 2 possible outcomes ($150,000 or $0) and it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.
To complicate things further, the entity must also consider factors surrounding constraining estimates of variable consideration – the entity can only include the variable consideration 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.
Lawyers should recognize that when significant components of variable consideration are included in contracts it may be more difficult to estimate and recognize revenue. While ultimately variable consideration may be desired or unavoidable, its importance from an accounting perspective should be considered in the approach to negotiation and documentation. Downside can perhaps be controlled by including floors on the amount the consideration can be decreased. The upside can be enhanced by removing contingencies as to when the amount is determinable and drafting clarity on the related conditions.
Allocate the Transaction Price to the Performance Obligations in the Contract
For a contract that has more than one performance obligation, the fourth step requires an entity to 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.
The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.
To meet the allocation objective, an entity should generally allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis. The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. If a standalone selling price is not directly observable, an entity should estimate the standalone selling price at an amount that would result in the allocation of the transaction price meeting the allocation objective discussed above.
An entity should allocate a variable amount (and subsequent changes to that amount) entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation if both of the following criteria are met:
- The terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service).
- Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective discussed above when considering all of the performance obligations and payment terms in the contract.
The following example is instructive:
An entity enters into a contract with a customer for two intellectual property licenses (Licenses X and Y), which the entity determines to represent two performance obligations each satisfied at a point in time. The standalone selling prices of Licenses X and Y are $800 and $1,000, respectively. According to the contract, the entity transfers License Y at inception of the contract and transfers License X three months later.
The price stated in the contract for License X is a fixed amount of $300, and for License Y the consideration is 5 percent of the customer’s future sales of products that use License Y. The entity’s estimate of the sales-based royalties (that is, the variable consideration) is $1,500.
The entity concludes that even though the variable payments relate specifically to an outcome from the performance obligation to transfer License Y (that is, the customer’s subsequent sales of products that use License Y), allocating the variable consideration entirely to License Y would be inconsistent with the principle for allocating the transaction price since it does not reflect the standalone price.
When License Y is transferred at the inception of the contract, the entity recognizes $167 of the $300 of the stated price of License X as revenue ($1,000 ÷ $1,800 × $300). When License X is transferred three months later, the entity recognizes $133 of the stated price of License X as revenue $133 ($800 ÷ $1,800 × $300).
Stated prices in contracts may vary from standalone selling prices to satisfy one of the party’s needs. However, the stated prices are not necessarily recognized under the new revenue pronouncement. Lawyers should have an understanding as to how the stated prices were determined, and then obtain input from all of the client’s constituencies. The sales team may be able to make a sale based on given prices, but the accounting team could find the results unpalatable, or management may be surprised at the result. In the foregoing example, the result may have been avoided by drafting two separate contracts if License X and License Y had two different commercial objectives and were otherwise unrelated.
Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation
The final step provides 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:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- 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.
- 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 the following:
- The entity has a present right to payment for the asset.
- The customer has legal title to the asset.
- The entity has transferred physical possession of the asset.
- The customer has the significant risks and rewards of ownership of the asset.
- The customer has accepted the asset.
The following example is straightforward and fairly intuitive demonstration of recognizing revenue over time because the customer simultaneously receives and consumes the benefits provided by the entity’s performance:
An entity enters into a contract to provide monthly payroll processing services to a customer for one year.
The promised payroll processing services are accounted for as a single performance obligation. The performance obligation is satisfied over time because the customer simultaneously receives and consumes the benefits of the entity’s performance in processing each payroll transaction as and when each transaction is processed. The fact that another entity would not need to re-perform payroll processing services for the service that the entity has provided to date also demonstrates that the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs.
Note that in this example timing of payments is irrelevant and the entity recognizes revenue over time by measuring its progress toward complete satisfaction of that performance obligation.
The following example arrives at a different result where the amount and timing of the payments are relevant to revenue recognition:
An entity enters into a contract with a customer to build an item of equipment. The payment schedule in the contract specifies that the customer must make an advance payment at contract inception of 10 percent of the contract price, regular payments throughout the construction period (amounting to 50 percent of the contract price), and a final payment of 40 percent of the contract price after construction is completed and the equipment has passed the prescribed performance tests. The payments are nonrefundable unless the entity fails to perform as promised. If the customer terminates the contract, the entity is entitled only to retain any progress payments received from the customer. The entity has no further rights to compensation from the customer.
When determining whether its performance obligation to build the equipment is a performance obligation satisfied over time, the entity considers whether it has an enforceable right to payment for performance completed to date if the customer were to terminate the contract for reasons other than the entity’s failure to perform as promised. Even though the payments made by the customer are nonrefundable, the cumulative amount of those payments is not expected, at all times throughout the contract, to at least correspond to the amount that would be necessary to compensate the entity for performance completed to date. This is because at various times during construction the cumulative amount of consideration paid by the customer might be less than the selling price of the partially completed item of equipment at that time. Consequently, the entity does not have a right to payment for performance completed to date.
Lawyers should realize that revenue recognition may not solely depend on the timing of payments. Recognition of revenue over time relates in part to consumption of benefits, customer control over the asset or being assured of adequate payment. While the foregoing are not exclusively related to legal concepts, contract drafting can be used to bolster the necessary indicia to recognize revenue. Appropriate drafting will be dependent on the facts and circumstances. The facts and circumstances can likely be identified by asking the client “How are we going to recognize revenue and what facts will help make that determination?”
Recognizing revenue at a point in time is more exclusively related to legal concepts, such as a right to payment, legal title, physical possession and customer acceptance. Where these concepts are the lynch pin to recognizing revenue they should be clearly drafted into the contract.