Companies that have relied on the “residual method” for allocating revenue to multiple-element arrangements probably will need a new game plan—and soon.
The Emerging Issues Task Force of the Financial Accounting Standards Board has reached a final consensus in Issue 08-1, which focuses on how to allocate revenue when companies are on the hook for multiple deliverables in a single transaction with a customer. That typically includes products like software or durable goods that often are sold with service or maintenance promises attached.
The EITF determined at its most recent meeting that FASB should give companies greater flexibility than they have to allocate revenue to the various pieces and parts of a multiple-element obligation. However, the board should also do away with the residual method that companies commonly use now, EITF decided—a move “not without controversy,” says Jay Hanson, national director of accounting for McGladrey & Pullen and a member of the EITF. “There will be system changes and cost” for those that use the residual method currently, he said.
The EITF received an unusual number of comment letters on the proposal, many of them pleading with the task force to spare the residual method, Hanson said. FASB will consider EITF’s recommendation at a meeting later in September, according to Hanson. Given FASB’s typical observation of and participation in EITF’s due process, rejection of EITF recommendations is rare.
The EITF has been looking at a number of revenue recognition issues in recent months, trying to adapt accounting rules to more modern realities about how companies do business, says Hanson. Companies have long been forbidden from recognizing any portion of the revenue related to a multiple-element arrangement unless they had direct evidence of how to price the various elements and recognize them as delivered, or they could look to comparable companies and follow their pricing. The residual method provided a means for recognizing portions of revenue when some direct or third-party evidence was available, but some was not.
EITF’s recommendation says companies should be allowed to use their own internally developed estimates when they don’t have specific pricing information, and they should no longer rely on the residual method. Hanson said companies will like the added flexibility to estimate pricing where no direct or third-party evidence of pricing is available, as it will enable them to recognize revenue earlier than they might have otherwise.
However, those that have relied on the residual method probably have some work to do to adapt to the new method, said Sue Cosper, a partner at PricewaterhouseCoopers in a recent Webcast on current financial reporting issues. “Companies will be required to develop the best evidence of selling price,” she said. “This is a significant change for companies that use the residual method.”
Hanson and Cosper said disclosures using the new method are significant. The new guidance likely will allow companies to adopt early, said Cosper, but companies should get started soon if they intend to do so. “For those that applied the residual method or were unable to separate and allocate arrangement consideration under the old model, the disclosure provisions under the new model will be onerous."