An agreement between the U.S.-based Financial Accounting Standards Board, or FASB, and the International Accounting Standards Board creates new generally accepted accounting principles, or GAAP, for revenue recognition -- that is, when to book income from sales. Although the rules don't take force until 2017, many companies are already planning for the changes, according to PWC, an accounting firm. The new standards create a five-part model in which a business identifies the contract, separates performance obligations, determines transaction price, allocates transaction price and recognizes revenue. Different rules pertain to certain types of contracts, such as those for insurance and leases.
Identifying the Contract
FASB defines a contract as an agreement with enforceable rights and obligations between two or more parties. The rules apply to written and oral contracts as well as to contractual arrangements implied by normal business practices. The parties are to apply the new GAAP rules separately to each contract, although they can combine certain contracts that meet specific criteria.
Identifying Performance Obligations
Contracts may contain promises, known as performance obligations, to transfer goods or services to a customer. The new GAAP rules explain how to determine if two or more obligations are distinct or combined. Companies account for combined obligations as a single unit. The rules also guide companies on how to handle performance obligations that are contingent upon third parties.
Determining Transaction Price
A seller expects cash or some other consideration when it transfers goods or services to customers. FASB lists four considerations for determining transaction price: (1) Predicting the most likely value when the contract calls for payment based upon one or more variables; (2) Adjusting for the time value of money; (3) Measuring non-cash consideration; (4) Reducing the transaction price if the seller pays consideration to the customer, such as via a special purchase credit. Businesses should not include customer credit risk when determining transaction price.
Allocating Transaction Price
When a contract has multiple performance obligations, the seller must properly allocate revenue received among the obligations. The seller uses the real or estimated standalone price of each obligation to allocate revenue. The GAAP rules discuss when to allocate a discount to specific goods and services promised in the contract. If the transaction price changes during the contract, the seller updates revenue in the period of the price change.
The model's final step discusses how to determine when a seller fulfills a performance obligation by transferring control of goods or services to the customer. GAAP distinguishes between transfers that occur over time versus those that occur at a point in time, and gives criteria as to when the seller should recognize revenue earned over time. It also lists five different events that indicate the seller transferred goods or services at a point in time. These events include the seller's right to receive payment, the customer taking legal title to goods and physical transfer of goods. The GAAP rules also discuss special topics, including consignment arrangements and repurchase agreements.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.