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The new standard at a glance
The FASB and the IASB recently issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, their new standard on revenue. This article summarizes the new requirements and what they will mean for the telecommunications industry.
The new standard replaces virtually all U.S. GAAP revenue guidance (including industry-specific) with a single model. It is codified in a new Topic 606 in the FASB Accounting Standards Codification®
(ASC) and is based on steps outlined in the following graphic:
Timing of revenue
ASC 606 requires revenue to be recognized as the work is performed if, and only if, control over the promised goods or services is transferred to the customer over time. Broadly, this occurs if one of the following conditions applies:
- The customer simultaneously receives and consumes the benefits.
- The customer controls the asset as it is created or enhanced.
- The asset has no alternative use, and the supplier is entitled to payment for performance to date and expects to fulfill the contract.
A customer contract may cover a bundle of goods or services. ASC 606 requires performance obligations to be accounted for separately if they are distinct, such as in the following examples.
- The customer benefits from the item on its own or along with other readily available resources.
The supplier does not provide a significant service of integrating the various performance obligations.
If performance obligations are distinct, the contract price is allocated between them based on the estimated standalone selling price of each performance obligation.
If pricing is variable or contingent (for instance, in the case of performance-based fees), revenue is recognized on a best-estimate basis. This may be the single most likely amount or an expected (probability-weighted) value. Variable revenue is also subject to a constraint aimed at ensuring that the amount recognized will not later be subject to a significant reversal due to a change in estimates.
The collectibility of the ultimate amount of revenue must be considered probable before revenue is recognized.
If the contract includes a significant financing component, the contract price must be adjusted for the effects of the time value of money. As a practical expedient, the financing component can be considered not significant if there is one year or less between performance and payment.
Contract fulfillment costs are recognized as assets if they are expected to be recovered and other conditions are met. The incremental costs of obtaining a contract must be capitalized if similar conditions are met.
ASC 606 also provides specific guidance on various other transaction types, including the following:
Rights of return and other customer options
Supplier repurchase options
Principal versus agent (gross versus net)
Licensing intellectual property
Nonrefundable upfront fees
Consignment and bill-and-hold arrangements
ASC 606 will require considerably more disclosure about revenue, including information about the following:
- Customer contracts, such as the remaining performance obligations (backlog)
Key judgments made
Contract costs recognized as assets
Transition and effective date
ASC 606 is effective for public entities in annual periods beginning after Dec. 15, 2016, including interim periods therein, and for private entities in annual periods beginning after Dec. 15, 2017. Earlier application is prohibited for public entities. Private entities may adopt the guidance early in years beginning after Dec. 15, 2016. The transition is retrospective, subject to various practical expedients, or modified retrospective, whereby an entity will apply the guidance only to contracts that are not completed at the date of adoption.
Impact on telecommunications
We believe the impact on the telecommunications industry will include the following: Existing revenue recognition literature, including ASC 605, will be superseded and replaced by ASC 606.
Contracts that provide multiple goods and/or services, such as a contract for a handset and monthly service, must be evaluated under ASC 606 to identify “distinct” performance obligations. As a result, different performance obligations may be identified than those identified using the standalone value criteria under the current guidance.
An entity will allocate the transaction price among all performance obligations on a relative standalone selling price basis, which is similar to existing U.S. GAAP. However, ASC 606 supersedes the strict hierarchy of vendor-specific objective evidence, third-party evidence and management’s estimate for determining standalone selling price in existing guidance. Under ASC 606, an entity will first look to the observable selling price of a performance obligation, and if the standalone selling price of a performance obligation can’t be observed, an entity must estimate it. A residual approach to estimate a standalone selling price may be applied in limited circumstances.
Wireless communications companies have historically accounted for the device provided and monthly service as separate units of accounting. They will now need to consider if bundled arrangements contain multiple performance obligations and when and how those obligations are fulfilled, even if the items are provided free under the contract. Under the new revenue standard, entities will likely need to consider whether bundled offerings include more than one performance obligation, and they might allocate a greater amount of revenue to the handset than under current guidance. In addition, they should enhance documentation and systems to comply with the new standard.
Consistent with current practice, activation fees will not typically correspond to a separate performance obligation, because no good or service is transferred to the customer as a result of the “activation.” Therefore, these fees are typically considered to be upfront payments for future services. Further, the recognition period for all or a portion of these fees could extend beyond the initial contract term length if the customer can renew the contract with no additional fee.
Entities will be required to evaluate whether installation services represent a distinct performance obligation. For example, if a technician must lay a physical line to connect cable, data or phone service to a customer’s residence or place of business, and the line could be used by other communications providers if the customer later changed providers, this performance obligation would likely be considered a distinct performance obligation.
Volume discount incentives: In determining the transaction price, an entity should evaluate volume discounts as a variable consideration and estimate the amounts.
Additional purchase options: The right to purchase additional goods or services at a discount or even no charge should be considered a separate performance obligation if the option represents a material right that the customer would receive only by entering into that contract. These purchase options may result in a portion of the transaction fee in effect being paid in advance. That portion should be deferred and recognized when the performance obligation for the additional goods or services is satisfied or the option expires.
Contract acquisition and fulfillment costs
The new standard now requires the incremental contract acquisition to be capitalized. This includes commissions, fees paid to third parties and provisioning activities. An asset is also recognized for fulfillment costs that are outside the scope of other U.S. GAAP and meet all the following criteria:
- The costs directly relate to the contract.
The costs aid in satisfying future performance obligations.
The costs are expected to be recovered.
These new requirements could significantly affect telecommunications companies. While current standards allow these costs to be capitalized when certain considerations are met, the new standard requires greater capitalization of costs than is common in the industry.
The amortization of the assets resulting from contract acquisition and fulfillment costs will be consistent with the pattern of when the related goods and services are provided. As a practical expedient, companies can expense the costs of obtaining a contract when the costs are incurred if the amortization period would be less than one year.
Recognizing these costs over time rather than expensing them as incurred could significantly affect operating margins compared with the current model.
Right of return
The new standard does not change the requirement that revenue be recognized only for amounts not expected to be returned. However, the existence of a right of return makes the price variable and subject to the constraint. This might result in a difference in the timing of revenue recognition to the extent an entity concludes that the estimated amount differs from the estimate under existing U.S. GAAP. Consistent with existing GAAP, rights of return can be contractual or based on an entity’s customary practice.
ASC 606 requires an entity to recognize estimated returns to be received as a refund liability (the equivalent sales amount of the product estimated to be returned), as well as a corresponding asset (carrying the amount of the product estimated to be returned, less the expected costs to recover) separate from inventory. The return asset is assessed for impairment and is not subject to the lower of cost or market testing, similar to inventory.
Under ASC 606, the assessment of the estimated amounts should be updated at the end of each reporting period, and any changes are recognized as an increase or decrease in revenue.
All entities, especially those with contracts running longer than one year, will be required to provide disclosures beyond those currently required.
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