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Journal Entry — Revenue — Boards Discuss Collectibility, Constraint, and Identifying a Contract

Published on: Jul 26, 2013

At their joint meeting this week, the FASB and IASB reached tentative decisions on three “sweep” issues associated with their revenue recognition project: (1) collectibility related to credit risk (in contracts without a significant financing component), (2) the revenue constraint in the determination of the minimum amount of variable consideration, and (3) the guidance entities would apply to a contract that does not meet the criteria in step 1 of the proposed model.

Collectibility Related to Credit Risk

Under the boards’ proposed revenue recognition model, credit risk would be evaluated as either (1) a component of variable consideration (e.g., an implicit price concession) or (2) an impairment consideration (e.g., bad debt). Entities have expressed concern that the model creates a tension because price concessions are considered in the analysis of variable consideration (i.e., gross revenue) and bad debt is shown prominently in operating expenses (if material). To address this concern, the boards tentatively agreed to:

  • Clarify that an entity’s objective under step 1 of the model is to make a qualitative assessment of the facts and circumstances and thereby determine whether there is a contract to which the guidance in the proposed standard applies.
  • Clarify that the amount of revenue to be recognized would be determined in other steps of the model.
  • Include guidance on determining whether the credit risk associated with a customer should be accounted for as a price concession (presented as an adjustment to gross revenue) or bad debt (presented as an operating expense).

Constraint for Variable Consideration

The boards tentatively agreed that in contracts with variable consideration, an entity would recognize revenue by estimating the consideration to which it is entitled and potentially adjusting that amount in accordance with the proposed “constraint” guidance. Under the constraint guidance, if the estimated consideration is subject to significant reversal, revenue would be recognized on the basis of the “minimum amount” of consideration that would not result in a significant revenue reversal. The entity would subsequently “true up” the amount of revenue recognized on the basis of its estimate of the minimum amount each period. Further, the minimum amount would be the basis for recognizing revenue regardless of whether the performance obligations in the contract are satisfied at a point in time or over time.

The example below is similar to one discussed by the boards at the meeting.

Example: A publisher enters into a contract to sell $1 million worth of books to its customer (a bookstore) and agrees that the customer does not have to pay for any books that the customer cannot resell. The consideration is variable: it could be less than $1 million, depending on whether the customer resells the books. Because control of the books is deemed to transfer to the customer upon delivery, the publisher’s performance obligation would be satisfied and revenue (subject to the constraint) would be recognized at that point. The publisher expects that the customer will resell $800,000 worth of books; however, that amount could be as low as $400,000. Under the proposed revenue guidance, the publisher would recognize $800,000 of revenue upon delivering the books to the customer, but only if the publisher concludes, on the basis of the factors listed in the proposed guidance, that subsequent changes in the expected amount of variable consideration will not result in a significant revenue reversal.

In accordance with the boards’ tentative decision, if subsequent changes in the expected amount of variable consideration could result in a significant revenue reversal, the publisher would not recognize the $800,000; rather, it would recognize the “minimum amount” of variable consideration that would not result in a significant revenue reversal. In this example, the publisher would have to determine the “minimum amount” to be recognized upon delivering the books; that determination would require significant judgment. Such amount could be the $400,000 if the publisher does not believe that the variable consideration is subject to significant revenue reversal; however, the amount could be zero if the publisher does not have sufficient confidence that the customer will resell any books. The publisher would need to “true up” the amount of revenue recognized on the basis of its revised estimate of the minimum amount each period.

Accounting for Contracts That Fail to Meet the Criteria in Step 1 for Identifying a Contract

The boards tentatively agreed to revise the guidance for a contract that fails to meet the criteria in step 1 of the proposed model. Specifically, they proposed to clarify that an entity would not recognize revenue from such a contract until all performance obligations in the contract have been satisfied and certain other criteria are met — i.e., the entity collects all promised consideration (or the contract is canceled) and the consideration is nonrefundable. This decision addresses concerns that entities could recognize revenue for contracts that do not meet the criteria in step 1 (and thus would be excluded from the scope of the revenue model) earlier than they would recognize revenue for contracts that meet the step 1 criteria and would therefore be subject to the proposal’s principles.

Also, the boards tentatively decided to remove the derecognition guidance for contracts that fail to meet the criteria in step 1 of the proposed model. Alternatively, the boards will rely on existing derecognition guidance in IFRSs and U.S. GAAP as well as add guidance for the sale of nonfinancial assets in the consequential amendments.

Finally, the boards tentatively decided to clarify that if an entity determines that a contract does not meet the step 1 criteria, such determination must be reassessed each reporting period.

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