The revenue recognition principle states that a company or a business owner is entitled to record its earned revenue. It implies that as long as the firm obtains revenue, it is legal to record it even before its collection time. For instance, if the snow plowing services complete plowing a company's parking area at a standard fee of $120. The service deliverer is right to recognize the revenue immediately; the task is over even though he or she is free to collect the payments after sometimes. The entire concept of revenue recognition has its foundation on the accrual basis of accounting (Lynch, & Pryor, 2018). Accrual accounting deals with recording revenues when earned and incurred expenses within a business. In this article, the focus is on the revenue recognition principle. Particularly, the discussion is on the new standard under the revenue recognition principles. Further, part of the discussion is on some examples of how the new standards of the revenue recognition principle affect different industries, mostly the software and the construction companies. The last part of the discussion will touch on some of the advantages and disadvantages of the revenue recognition standards on both the business and economy as a whole.
The Revenue recognition standards
The ASC 606 and IFRS 15 are the new revenue recognition standards that affect all businesses that enter into contracts with customers to transfer goods or services public, private, and non- profit entities. Publicly held companies should abide by the new requirements documented on the ASC 606 docket. The ASC 606 codes result from a joint function between the Financial Accounting Standard's Board (FASB) and International Accounting Standards Board (IASB) (Lynch, & Pryor, 2018). The codes provide a framework for businesses to have a consistent manner of recognizing their revenue. The aim set by the Financial Accounting Standard's Board (FASB) jointly with the International Accounting Standards Board (IASB) is to eliminate the variation that exists among business as they handle accounting issues for a similar transaction. From the joint statement released by the two bodies, there is a difference or the lack of standardization. Lynch & Pryor (2018) discuss that investors and other consumers of financial statements face difficulties while comparing results across companies within the same and different industries.
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It is time for any business registered under the FASB and the IASB to try and meet all these regulations for them to authenticate their accounting transaction and activities to aid in smooth running. However, the first step is to understand the new standards and also understand how it impacts the business. The core principle of Topic 606 is "a firm should recognize revenue to depict the transfer of 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" (Lynch, & Pryor, 2018). An entity should perform the following five-step analysis. The first step is to identify the contract or the contracts with the customer to achieve the core principle of Topic 606. An agreement between a customer and a business can either be oral, written, or implied. A valid contract, as outlined in this standard, must satisfy the following needs. It must be approved, identify each party, have commercial substance, and identify the payments terms (Penman & Yehuda, 2019).
The second step is to identify the performance obligation in the contract. By definition, the performance obligation is the promise in a contract to transfer services or goods. Regarding the issue, a promised good or service must be distinct. It is the only way through which it can be accounted for as a separate performance obligation when there are multiple promises in a contract. Penman & Yehuda (2019) states, "a good or service is distinct if the customer can benefit from the good or service either on its own or together with other resources readily available to the customer and the entity's obligation to transfer the good or service is separately identifiable in the contract."
The third step is to establish or determine the price charged for the transaction, which is the amount of consideration to which an organization is entitled to as a fee for transferring the promised services or goods to a customer. It amount excludes the amount collected on behalf of the third party (Holloway, Sutton & Swafford, 2017). The fourth step is the allocation of the transaction prices to the performance obligations. The standalone selling prices are the basis of the allocation of the transaction prices to the various performance obligations. However, the entity has the option to adjust expected cost, the residual approach or the market approach to allocate the transaction process to various performances obligation for any contract in the absence of the standalone selling prices. The last part is to recognize revenue. After the process is nearing its end, the organization is entitled to recognize the revenue (Rutledge, Karim & Kim, 2016). Hence, the company recognizes revenue when performance obligations are satisfied by transferring control of a promised good or service to a customer — control either transfers at a specific point in time or overtime.
The Application of the Revenue Recognition Standards to Construction Industry
There are numerous ways through which the revenue recognition standard apply or impact the construction industry. The first impact is on multiple performance obligations. A company in the commercial construction must evaluate if the deliverables are different from each other in the overall context of the contract in a situation where there are multiple deliverables in a settlement. The commercial construction company should then treat each of the deliverables in a separate performance obligation, and in each of the performance obligation level, recognize the revenue. Besides, a construction company is obliged to treat a contract as a series of performance obligation in a situation where the contract is for the multiple units where there is a distinction between each unit. "The company will then recognize revenue at each unit based on percent complete of each respective unit. If the units are not distinct, then the entire contract will be treated as a single performance obligation" (Rutledge, Karim & Kim, 2016).
Furthermore, the recognition standards also affect construction companies with regards to the cost of obtaining and fulfilling the contract. For any project under the construction company, the incremental cost of contract obtainment needs to be amortized and differed over the life of the contract. In this case, the amortization approach should be consistently in line with how a construction company recognizes the project’s revenue. The company may elect a practical expedient to immediately expense the cost if the amortization period is one year or less. Rutledge, Karim & Kim (2016) argue that the firm should similarly account fro the contract fulfillment cost, which only exempts a situation where there is no practical expedient available for the fulfillment of the contract cost for the commercial company project.
Combined contracts for the construction companies will also feel the impact of the revenue recognition standards, mostly the revised version or topic 606. Under the revenue recognition standards, the construction company has to combine the contracts under a condition that they are entered at similar or at the same time with the same client. At the same time, the firm should meet some conditions in this situation (Holloway, Sutton & Swafford, 2017). For instance, the goods or services under which the contract promises must be single performance obligation, further; the contracts must be a negotiated package deal with a single commercial objective.
The construction companies also should adopt some methods that will be important for them to take new recognition standards. Such companies will have to disclose the adoption of topic 606 in addition to calculating the impact on their financial statements (Holloway, Sutton & Swafford, 2017). Two methods are applicable in this case. The first method is the retrospective approach. Under this approach, the construction companies need to implement the standards for the years that feature on the financial statements in the years of the adoption. For instance, if a company adopts the standards in the year 2019, the comparative financial statement of both the year 2018 and 2019 must be under topic 606 (Rutledge, Karim & Kim, 2016). Also, it may entail revising the company's 2018 financial statement to be consistent with the standards. The second adoption approach is the modified retrospective method. Under this approach, the construction company is only required to apply the new revenue standard to the financial statements for the year in which the firm should adopt topic 606.
The Application of the Revenue Recognition Standards to software Industry
The software industry is one of the industries that is affected by the revenue recognition standards, mostly the revised version 606. The degree of effects that most of the software companies expose themselves depends on the level and the nature of the revenue. Those companies with software license revenue will be most affected, while there is likely a lesser impact on the recognition of software-as-a-service (SaaS) revenue (Holloway, Sutton & Swafford, 2017). Notably, most of the software companies prefer one contract where they make arrangements with customers and wrapped many components in a single contract. The components could potentially include software licenses, SaaS, post-contract customer support (PCS), and other goods or services. However, Kerry Canfield, C. G. F. M & PMP (2018) assert that the revised version of the revenue recognition standards or Topic 606 will change most of these operations.
In the software companies, the new or the revised revenue recognition version, for example, will results in the elimination of the requirement for vendor-specific objective evidence of fair value and this will impact the software companies. Further, the standard will make it difficult on the valuation of the products or services. For instance, it will introduce potential difficulty in determining the fair value of software licenses in an arrangement. Other than that, the companies within the software industry will also find it challenging to evaluate the appropriate accounting for hybrid license arrangements for their operations. In addition to that, these entities will further face challenges or complexities in assessing, hosting, and term-based license arrangements (Kerry Canfield, C. G. F. M & PMP, 2018). Finally, the new version of the revenue recognition standards will also have an impact on the timing of revenue recognition for royalty arrangements or arrangements with resellers. These changes will not only demand some adjustments from the company structure and financial issues but will also require the use of new judgments and estimates within the company.
The revenue recognition standards also have a significant impact on the software-as-a-service (SaaS) revenue. It is true that even when other entities feel the grueling impacts of the new revenue recognition standards, SaaS entities may not feel the intensity of these laws on their operations. However, the new the experiences of public SaaS entities in the past years have shown the SaaS entities should be wary of the potential headache the revenue recognition standards mostly the topic 606 can have on their operations. With topic 606 come numerous changes that can potentially hamper the SaaS operations (Kerry Canfield, C. G. F. M & PMP, 2018) The changes may include the changes that link to relate to the allocation of discounts in an arrangement. Besides, "the elimination of certain restrictions that limited the amount of revenue that may be recognized when contracts had extended payment terms or increasing annual billings can also be part of the changes that my affect SaaS entities" (Kerry Canfield, C. G. F. M &PMP, 2018). The last changes that may also link to SaaS are the accounting for set-up and activation fees.
Besides, the software and SaaS entities must also feel the impact of the revenue recognition standards that links to the accounting for costs to obtain contracts. These include many aspects, mostly the internal controls over financial reporting, the commission payments, and disclosure requirements. The disclosure requirements, in this case, include the requirement for disclosures about performance obligations such as disclosures commonly referred to as "backlog disclosures" (Kerry Canfield, C. G. F. M & PMP, 2018). Therefore, both SaaS and software companies are not safe. These entities have no other option but to ensure that they abide by the standards set by the bodies so that there is consistency with regards to accounting activities within their operations.
Merits and Demerits of the standards
Adopting the revenue recognition standard is critical in many ways for a company. First, it is a universal standard that impacts most of the companies that are within an industry. There is a rise in the adoption rate of the International Financial Reporting Standards (IFRS) in all parts of the world. Currently, 119 countries in the world share the global accounting standards, and this improves investment and borrowing efficacy for the domestic and global organization. It also enhances the quality of the accounting standards for all global accounting organization (Penman & Yehuda, 2019). Secondly, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) enhances reporting consistency in accounting. The goal of this joint operation is to ensure that there is a consistency in accounting reports for a similar transaction worldwide. The new standard provides one framework which should produce more comparable financial statements.
Finally, the revenue recognition standards mostly, topic 606, aims at improving planning, budgeting, and performance management for accounting firms and companies. The revenue recognition standers are part of the financial statements that have been used in many years to plan, report, and also aid in budgeting for many companies. "IFRS 15 and ASC 606 have made improvements in this regard. The companies require forecasts to make new standards. These forecasts can enable stronger revenue and cash flow budgeting" (Penman & Yehuda, 2019). Moreover, they would also aid in tracking for the progress and provide information that is good for the stakeholders. All these are good for the organization's financial planning. However, some negative issues can come as a result of revenue recognition standards. First, the cost of implementation and adaptation is not only cost consuming, but also time-consuming mostly for the small business. Further, some companies and researchers also warn that adopting the standards is likely to lead to global auditing and reinforcement consistency, and this would disadvantage several entities in the world. Further, others also claim that these standards are likely to create an adjustment period filled with tumult (Lynch, & Pryor, 2018).
In conclusion, the revenue recognition principle plays a significant part in attempting to create standards for the accountants to create consistency for all accountants doing a similar transaction. Also, from the discussion, it evident that numerous industries are likely to undergo intense changes as a result of this principle, particularly its revised version. However, there are also benefits such companies are likely to accrue when they adopt the standards, but only if they can be in a position to minimize the challenges that come alongside its adoption.
References
Holloway, A., Sutton, J., & Swafford, M. (2017). Healthcare revenue recognition: 5 steps for net revenue modeling and reporting considerations. Healthcare Financial Management , 71 (1), 64-70.
Kerry Canfield, C. G. F. M., & PMP, C. (2018).Applying the Basics of Federal Financial Management to SaaS Delivery Models. The Journal of Government Financial Management , 67 (1), 42-47.
Lynch, N. C., & Pryor, C. R. (2018). The Impact of the New Revenue Recognition Guidance on Cloud Computing Arrangements. The CPA Journal , 88 (6), 38-45.
Penman, S. H., & Yehuda, N. (2019). A matter of principle: Accounting reports convey both cash-flow news and discount-rate news. Management of Science .
Rutledge, R. W., Karim, K. E., & Kim, T. (2016). The FASB's and IASB's New Revenue Recognition Standard: What Will Be the Effects on Earnings Quality, Deferred Taxes, Management Compensation, and on Industry‐Specific Reporting?. Journal of Corporate Accounting & Finance , 27 (6), 43-48.
