Charles Kinslow

Professor Guarav Kumar

International Accounting

May 6, 2013

Revenue Recognition – Joint Project of the FASB and IASB

The Financial Accounting Standards Board (FASB) and the International Accounting Standards

Boards (IASB) convened in September 2002 at a meeting in Norwalk, Connecticut, during which an

agreement was established regarding convergence efforts to take place during the future. The two

organizations agreed on a mutual undertaking to put their best efforts forth to accomplish the following:

(1) Complete compatibility of their respective financial reporting standards as soon as

practicable; and

(2) Coordination of a work program designed to establish full compatibility and sustain it once

achieved.

The meeting was later termed the “Norwalk Agreement.” The agreement included several FASB

initiatives aimed at furthering convergence between IFRS and U.S. GAAP. For example, one of the

provisions called for establishing joint projects concentrating on a particular issue of importance in moving

toward complete compatibility. These projects would involve the sharing of personnel resources between the

two organizations and the establishment of a similar time schedule to be followed by both in working

together to complete the project in a reasonable amount of time. These joint projects address several

important topical areas where significant discrepancies exist between the reporting standards of the FASB

and the IASB, including revenue recognition, business combinations, and conceptual framework review.1

This paper will focus on the joint project regarding revenue recognition and the efforts by the Boards to

finalize a uniform standard.

1Timothy Doupnik and Hector Perera, International Accounting (New York: McGraw-Hill Irwin, 2012) 101.

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Joint Project on Revenue Recognition - Overview

The revenue recognition convergence project was designed to accomplish several objectives,

including:

(1) Removal of inconsistencies and weaknesses in current revenue requirements;

(2) Establishing a more robust framework for guidance on revenue issues;

(3) Enhancing comparability of revenue recognition methods across entities, industries,

jurisdictions and capital markets;

(4) Improving required disclosures to give financial statement users access to additional relevant

information;

(5) Streamlining the preparation of financial statements through a curtailment of the necessary

requirements an entity must comply with.2

A comprehensive understanding of the joint project on revenue recognition can best be gained by

detailing the key provisions in the publications issued as part of the Boards due process in crafting a new

standard, incorporating by reference subsequent modifications arising from re-deliberations, and comparing

and contrasting the resulting revised standard with current U.S. GAAP. A section outlining the potential

impact of the new standard on entities operating in specific industries is also included.

The Boards surmised that a uniform revenue recognition standard would play an integral role in

achieving convergence between U.S. GAAP and IFRS. The discussion paper and subsequent exposure drafts

published by the Boards collectively asserted that the establishment of a single standard would effectively

address the separate problems presented by the standard-heavy composition of U.S. GAAP and,

comparatively, the substantially limited guidance provided by current IFRS. The initial IFRS Framework set

forth two general assumptions regarding revenue recognition. First, a probable future economic benefit

inuring to an organization pursuant to a sale must be established. The second assumption requires a reliable

2 “Exposure Draft: Revenue from Contracts with Customers,” FASB, Web, June 2010. 2 February 2013: 7.

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valuation for the cost or value of the item in question.3 Subsequent guidance was provided by IAS 18

Revenue, IAS 11 Construction Contracts, and related interpretations. However, the standards and

interpretations have been characterized as difficult to understand and apply. As for U.S. GAAP, the uniform

standard would supersede numerous general and industry-wide standards and interpretations.4 This

convoluted composition of standards and interpretations has resulted in the prevention of any establishment

of a concise and consistent principle or set of principles for revenue recognition. Nevertheless, some general

characteristics can be extrapolated from the accounting literature. For example, the governing principle

underlying revenue recognition under U.S. GAAP requires that revenue be recognized when realized or

realizable and earned. Other general revenue recognition concepts under the present framework include the

following: (1) persuasive evidence as to the existence of an arrangement, (2) occurrence of performance of

delivery or provision of services, (3) fixed or determinable contract price, and (4) reasonable assurance

regarding collectability.5

The Boards proposed standard is intended to remedy the aforementioned deficiencies in the two sets

of standards by creating one approach for all contracts with customers, exempting only those obligations

addressed in the FASB ACCOUNTING STANDARDS CODIFICATION, such as leases and insurance

contracts.6 The approach would consist of a contract-based revenue recognition model in which the

recognition of revenue is based on accounting for the contract with the customer. The primary characteristic

of the model incorporates the proposition that when a company enters into a contract with a customer, the

associated contractual rights and obligations establish a net contract position. The net contract position is

characterized as a contract asset, contract liability, or a net nil position based on measurements of the

contractual rights and obligations outstanding. A company records revenue pursuant to increases in contract

3 Gallistel, David J. and Phan, Tuan. “IASB & FASB Convergence Project – Revenue Recognition,” Drake University.org, Drake Management Review, Web, October 2012. 1 May 2013: 4. 4 “Snapshot: Preliminary Views on Revenue Recognition in Contracts with Customers,” IFRS.org, IFRS, Web, December 2008. 12 Febuary 2013:2. 5 “Revenue Recognition – Potential Changes to U.S. GAAP,” FASB.org, FASB, Web, March 2012. 1 May 2013: 5. 6 “Wrapping up Revenue Deliberations: Boards Preparing to Issue Final Standard on Revenue Recognition,” Deloitte.com, Deloitte, Web, March 2013. 22 March 2013: 1.

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assets or decreases in contract liabilities, occurring independently or jointly, as contractual obligations are

fulfilled.7

The core principle of the standard comprises the concept that revenue should be recognized by an

entity in a manner that evinces the consideration received or expected to be received by an entity for goods

or services transferred to a customer, with a correspondingly accurate depiction reflecting the substance of

that transfer by the entity.8 The Boards assert that adherence to the principle requires execution of the

following steps:

(1) Identify the contract(s) with a customer;

(2) Identify the separate performance obligations in the contract;

(3) Determine the transaction price;

(4) Allocate the transaction price to the separate performance obligations; and

(5) Recognize revenue when the entity satisfies each performance obligation.9

Contract-based Revenue Recognition Model – Implementation Guidance and Comparative

Analysis with Current U.S. GAAP

Step 1: Identify the Contract(s) with the Customer

In identifying customer contracts, the Boards propose combination for multiple contracts with

interdependent prices. Alternatively, the standard would require segmentation of contracts where the

contracted-for goods and services are priced independently. The standard enumerates lists of factors for

entities to review in assessing whether specified contracts should be bundled or accounted for separately.10

Under current U.S. GAAP, combining and segmenting is allowed under certain circumstances. However,

7 “Discussion Paper”, 10-11. 8 “Exposure Draft: Revenue from Contracts with Customers,” 8. 9 “Tracking IFRS: Exposure draft on revenue recognition,” Deloitte.com., Deloitte, Web, August 2010. 27 March 2013: 2. 10 “Exposure Draft ED/2011/6: A Revision of ED/2010/6 Revenue from Contracts with Customers,” IFRS Foundation, Web, November 2011. 14 March 2013: 22, 25-26.

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U.S. GAAP does not mandate the combination or segmentation of contracts provided that the contract fairly

reflects the economic substance of the transaction.11

The standard also addresses the issue of contract modifications within the context of the proposed

model’s first step. The guidance provided by the standard is consistent with the treatment for original

contracts outlined above. For example, contract modifications would be combined with the original contract

if the pricing of the promised goods or services is interdependent.12 The cumulative effect resulting from the

addition of the modification would be recognized in the period in which the modification takes place.

Conversely, contract modifications would be treated as separate obligations if the price is considered

independent with respect to the original contract.13 U.S. GAAP refers to contract modifications as change

orders and prescribes a different approach for treatment of these items. For example, change orders are

recognized as part of contract revenue where the customer’s approval of the order is probable and the

incremental revenue can be measured on a reliable basis. Additionally, U.S. GAAP provides comprehensive

guidance regarding revenue and cost issues associated with change orders that delineate services to be

performed but that are not denominated in price.14

Step 2: Identify the Separate Performance Obligations in the Contract

The Boards introduce the concept of a “performance obligation” in expounding on the principles to

be followed in properly executing the first step of the model. The standard states that when a company enters

into a contract with a customer, the company is granted rights to payment from the customer and incurs

obligations to supply goods and services to the customer. The assumed obligations by the company are

termed performance obligations.15 The Boards propose that performance obligations should be treated as

separate contracts only when the obligations are transferred at different times and are distinct in nature. The

11 “IFRS and US GAAP: similarities and differences,” PWC.com. PricewaterhouseCoopers, Web, October 2012. 25 March 2013: 28. 12 “Exposure Draft ED/2011/6,” 22-23. 13 “Wrapping up Revenue Deliberations,” 3. 14 “Building toward the future: FASB/IASB Revenue Recognition Exposure Draft,” PWC.com, PricewaterhouseCoopers, Web, 2010. 13 March 2012: 4. 15 “Discussion Paper,” 11.

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goods or services provided for in the contract are considered distinct if the entity or another entity separately

sells an identical or similar good or service. A good or service is also considered distinct if it has a distinct

usefulness to the customer and is distinct within the context of the contract. The standard provides a list of

factors for entities to assess in determining whether a good or service is contextually distinct.16

Alternatively, current U.S. GAAP presumes that each individual contract consists of a profit center

comprising revenue recognition, cost accumulation, and income measurement. This basic presumption can

be overcome only if a contract or multiple contracts satisfy certain criteria for combination or segmentation

treatment.17 The Boards have specified in re-deliberations that the requirement of contextual distinction is

not determined by an assessment of the stand-alone value of a good or service as contemplated under current

U.S. GAAP. Accordingly, this provision may result in mandated combinations for entities that are not

required under current U.S. GAAP.18

Step 3: Determine the Transaction Price

The proposed standard defines transaction price as the amount of consideration an entity receives, or

anticipates receiving, on a contract for goods or services. 19 The transaction price can be a sum certain or can

vary based on items such as discounts, rebates, or contingencies. The standard proposes that entities consider

the following factors in estimating transaction price: (a) variable consideration, (b) the time value of money,

(c) noncash consideration, and (d) consideration owing to the customer.20 Entities would be required to use

either the “expected value” or “most likely amount” approach in ascertaining the transaction price. The

proposal states that the decision should be based on a consideration by the entity of which approach will

most accurately predict the consideration the entity is to receive.21 Conversely, current U.S. GAAP does not

16 “Exposure Draft ED/2011/6,” 25-26. 17 “Building toward the future,” 7. 18 “Wrapping up Revenue Deliberations,” 4. 19 “Exposure Draft ED/2011/6,” 33. 20 Ibid. 21 “Wrapping up Revenue Deliberations,” 5.

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permit the use of probability-based approaches in determining the recognition of contingent consideration.

Recognition of variable consideration is allowed only when the contingency has been resolved. 22

The new standard proposes a constraint on the inclusion of contingent consideration in the

determination of transaction price. An entity would only be permitted to include contingent consideration in

the transaction price if it has a “high level of certainty” that the associated revenues recognized would not be

subject to future reversals. The Boards provide a list of indicators for entities to reference in determining

whether to apply the constraint, including past experience with similar contracts and the presence or absence

of a significant degree of variance in potential consideration amounts.23

The Boards position also differs in other areas from approaches embodied in current U.S. GAAP. For

example, the new standard proposes that contract revenues should incorporate the impact associated with

time values of money where the effect is material. Additionally, the Boards assert that management should

utilize a discount rate that reflects a discrete financing transaction between the contracting parties and

accounts for credit risk.24 Alternatively, current U.S. GAAP requires revenue discounting in limited

circumstances, such as receivables with settlement dates in excess of one year. In the relatively few situations

where discounting is mandated, U.S. GAAP requires the computation of the interest component as a function

of the stated interest rate in the instrument unless the rate is unreasonable. In such cases, the standards allow

for the use of the market interest rate.25

Step 4: Allocate the Transaction Price to the Separate Performance Obligations

This step would require entities to allocate transaction price to discrete performance obligations

based on the underlying stand-alone selling price of the good or service. A number of methods are provided

for measuring the stand-alone selling price.26 The observable market price is advanced as the preferred

measurement but an allowance is made for use of methods involving estimation where the market price is not

22 “IFRS and US GAAP: similarities and differences,” 21. 23 “Wrapping up Revenue Deliberations,” 5. 24 “Building toward the future,” 6. 25 Ibid., 7 26 “Exposure Draft ED/2011/6,” 37-38.

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available. The estimation method chosen must maximize the use of observable inputs. Examples of permitted

methods include expected cost plus a margin and adjusted market assessment. Entities may also use a

residual approach when the selling price is highly variable or uncertain. 27

Under U.S. GAAP, the allocation of transaction price to separate performance obligations is

determined according to the following hierarchy based on availability: (1) VSOE (Vendor-Specific Objective

Evidence), (2) TPE (Third-party evidence), and (3) Estimated Selling Price. When the first two

measurements are unavailable, entities are required to ascertain a Best Estimate of Selling Price (BESP)

consistent with the methodology employed in determining the stand-alone value for the related deliverable.

Methods involving estimation are not expressly provided for.28 If the entity is required to use BESP, U.S.

GAAP states that consideration is to be apportioned at the inception date of the contract to all deliverables

using the relative selling price method. The residual method conditionally permitted for allocations under the

proposed standard for is expressly prohibited.29

Step 5: Recognizing Revenue when the Entity Satisfies each Performance Obligation

On the issue of the fifth step, the Boards set forth the principle that entities may recognize revenue

only when performance obligations have been fulfilled through contractually prescribed transfers of goods or

services.30 The Boards state that a transfer occurs when the customer acquires control of the transferred good

or service. Control is defined as the capacity to dictate the administration of a good or service and receive the

corresponding benefit. Receipt of the benefit of a good or service occurs when the customer possesses the

right to collect substantially all of the potential cash flows from the asset. The Boards state that control is

ultimately determined on a case-by-case basis but lists the following factors to consider in making the

assessment: (1) legal title, (2) physical possession, (3) unconditional obligation to pay; (4) specifications in

27 “IFRS and US GAAP: similarities and differences,” 22. 28 Ibid. 29 Ibid. 30 “Exposure Draft ED/2011/6,” 11.

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design or function unique to the customer; and (5) the ability of the customer to require changes to the good

or service of a significant nature according to the customer’s individualized requirements.31

The proposed standard provides a methodology for assessing whether the requisite transfer for

recognition has occurred in cases where control is transferred continuously rather than at a specific point in

time. For example, the Boards state that continuous control is present where the entity creates or enhances an

asset during the period in which the customer has obtained control of the asset. Additionally, continuous

control can be established where the company’s contracted-for performance does not produce an asset with

alternative use and one of the following factors are present: (a) benefit inures to customer upon performance

of each task, (b) re-performance of previous tasks to date would not be required to be undertaken by another

entity, or (c) the entity has acquired a present right to payment in accordance with prior performance.32

Further guidance is provided regarding the measurement of the progress of the performance

obligations required under the contract. The standard proposes the use of a single method (output or input)

applied consistently. 33 It also asserts that revenue should not be recognized until progress can be reasonably

estimated but contains a provision permitting entities to recognize revenue up to the costs incurred if the

entity can determine that the contract will not produce a loss.34 Other provisions on this issue state that the

cumulative amount of revenue an entity can recognize on a contract is subject to a “reasonable assurance”

test. Prospective revenues to be recognized are considered reasonably assured where the entity has

experience with similar contracts or other persuasive evidence and the past experience provides predictive

value as to the contract’s outcome.35

Except in the context of construction accounting, current U.S. GAAP does not provide additional

guidance pertaining to the sale of goods on a continuous basis.36 For construction contracts, U.S. GAAP

31 Ibid., 12. 32 “Exposure Draft ED/2011/6,” 11-12. 33 “Building toward the future,” 10. 34 Ibid., 9. 35 “IFRS and US GAAP: similarities and differences,” 33. 36 Ibid., 28.

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maintains a preference for the percentage-of-completion method. However, the completed-contract method is

mandated in certain circumstances. An example would be a situation where management cannot produce

reliable estimates. In this scenario, provided that assurances have been made that the contract will not result

in a loss, U.S. GAAP requires use of the percentage-of-completion method based on a zero profit margin

until reliable estimations can be made.37

Application of the Proposed Model – A Basic Illustration38

37 Ibid., 27. 38 Ciesielski, Jack and Weirich, Thomas. “Convergence Collaboration: Revising Revenue Recognition,” Management Accounting Quarterly, Web, Spring 2011. 29 April 2013: 3.

Step 1: Identify the Contract

Contractually-assumed promises to deliver goods or services.

Single Contracts Combination of Multiple Contracts Segmentation of Multiple Contracts

Step 2: Identify Performance Obligations Under the Contract

Amount of consideration an entity receives, or anticipates receiving, on a contract for goods or services.

Step 3: Determine the Transaction Price

Apportion to discrete performance obligations based on underlying stand-alone selling prices of goods or services.

Step 4: Allocate Transaction Price to Separate Performance Obligations

Recognize revenue only when performance obligations have been fulfilled through contractually-prescribed transfers of goods or services.

Step 5: Recognize Revenue Upon Completion of Performance Obligations

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Required Disclosures Per Proposed Standard

The disclosure provisions in the proposed standard would require entities to supply substantially more

information. As stated above, the Boards objective for these increased disclosures is to assist financial

statement users in their understanding of nature, amount, timing, and certainty issues regarding revenues and

cash flows associated with customers. Examples of the proposed required disclosures include the following:

• Disaggregation of revenues including a reconciliation of the disaggregated information to total

revenue;

• Certain information concerning changes in contract balances for accounts such as unbilled

receivables and deferred revenue;

• Aggregation of transaction price amounts allocated to performance obligations after application of

the constraint guidance for contracts with terms in excess of one year;

• An explanation of the entity’s expectation concerning the timing of recognition for revenues

associated with the above aggregated amounts for transaction prices;

• Specified information regarding assets recognized pursuant to costs incurred in acquiring or

satisfying a contract; and

• Information regarding methods, inputs, and assumptions relied upon in ascertaining transaction price

and its allocation to performance obligations.39

In contrast to the proposed standard’s centralized disclosure guidance, current U.S. GAAP provisions

regarding disclosure are spread across numerous industry-specific and general recognition standards.

Examples of these requirements include:

• General requirements (e.g., accounting policies, seasonal revenues, segments, related parties);

39 “Wrapping Up Revenue Deliberations,” 8-9.

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• Specific requirements (e.g., multiple-element arrangements, nonmonetary revenue transactions, bill-

and-hold, fees for services); and

• Industry requirements (e.g., construction contractors, franchisors).40

Ideally, the uniformity created by maintaining disclosure requirements for revenue recognition in a single

standard will make it easier for entities in ensuring compliance in this area. However, the extensive

disclosures mandated by the new standard will undoubtedly increase costs for entities relative to financial

statement presentation. These additional expenses, in the form of increased compensation to internal

personnel and third parties, may harm entities financially in both direct and indirect ways, as laborious

compliance efforts may result in reduced focus on other important business initiatives.

Projected Impact of the Proposed Standard in Specific Industries

The proposed standard would likely not produce material changes for most entities regarding revenue

recognition practices. However, practitioners have stated that the provisions would significantly impact

entities in certain industries, such as construction and software. For example, in the context of the

construction industry, companies could only recognize revenue during construction when the customer

controls the item constructed. Consequently, a construction company would be required to recognize revenue

for every transfer in the construction process resulting in customer control, regardless of the materiality of

the item transferred in relation to the contract price.41 A practical expedient included in the standard would

permit contractors to treat contract acquisition costs as period costs for contracts with an expected duration of

one year or less where the costs are either ineligible for capitalization under another standard or recovery of

the costs is unexpected. The inclusion of these alternatives may necessitate perpetual evaluation of contract

40 “FASB staff document: Revenue recognition – Potential Changes to U.S. GAAP,” FASB.org, FASB, Web, March 2012. 29 March 2013: 17. 41 Howard, Richard. “Revenue Recognition: Convergence between IFRS and U.S. GAAP,” Deloitte.com, Deloitte, Web, June 2012. 21 February 2013: 2.

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acquisition costs by entities in the construction industry, resulting in practicality concerns and the potential

for added costs.42

For software companies, the new standard would permit entities to estimate stand-alone selling prices

for undelivered contractual elements and recognize revenue separately for these components.43 This

allowance represents a substantial departure from U.S. GAAP, which, as stated above, requires objective and

reliable evidence of selling price for revenue recognition of separate elements. Additionally, the use of cost

accrual in accounting for warranties and product support services performed after the sale would be

disallowed. Rather, the new standard would require these companies to incorporate warranties and after sale

services into the contract and allow for revenue recognition only when those contractual promises are

satisfied. 44

The new standard also mandates initial recognition for expenses related to sales commissions. As

such, companies in the affected industries would no longer be permitted to recognize these costs over the

period of sale in accordance with current practice.45 Another noteworthy change proposed by the standard

regards the treatment of licenses and royalties. Under the proposed standard, revenue is recognized

immediately when the customer obtains control of the intellectual property through a sales transaction. A sale

is present if the transaction results in the customer’s acquisition of the exclusive right to use the good for its

economic life. Alternatively, if the customer does not retain the above-referenced exclusive right, the

absence of this control indicates the performance obligation has not been fulfilled. As such, the standard

requires the entity to recognize the associated revenue over the term of the license.46 Practitioners have

surmised that the standard’s use of estimates for royalties in connection with determining the transaction

price and its reliance on the principle of control will result in earlier revenue recognition. Additionally, it has

been suggested that this provision will impose additional burdens on companies to make assessments

42 “Wrapping up Deliberations,” 10. 43 “Revenue Recognition: Convergence between IFRS and U.S. GAAP,” 2. 44 Ibid. 45 Ibid. 46 “Tracking IFRS: Exposure draft on revenue recognition,” 7.

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regarding classification of the transaction as a sale as well as the determination of when customer control has

been obtained.47

Conclusion

At present, the Boards have finished their substantive re-deliberations of the second exposure draft.

Consequently, the Boards have commenced composing the final standard and have set January 1, 2017, as

the effective date for implementation of the new standard. Ideally, the proposed standard will add

considerable consistency for revenue recognition practices, providing centralized and comprehensive

guidance on the issue in comparison to the excessively convoluted or substantively deficient standards

present in other jurisdictions that produce inconsistencies. However, the standard’s heavy use of estimates in

its approach is likely to produce its own inconsistencies in recognition. This preference for the use of

estimation methods inherent in the standard’s principles-based approach is likely to cause friction with

countries that currently use rules-based approaches and view their methodologies as more precise. This

tension could continue to prolong the project’s completion and subsequent adoption. Nevertheless, the

Boards remain optimistic about the project’s future finalization and its creation of a standard with wide

constituent support that can greatly contribute to global convergence of accounting standards and practices.

47 “Revenue recognition: full speed ahead,” PWC.com. PricewaterhouseCoopers, Web, July 2010.1 March 2013: 7-8.

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