Technical consensus is starting to gel on certain aspects of the new revenue recognition accounting requirements taking effect in 2018, but the answers are still not nearly as cut and dried as traditional, rule-following accountants might like.

At the Securities and Exchange Commission, the Office of the Chief Accountant is taking questions on literally every step of the new five-step process that all companies must follow beginning in January for determining when and in what amounts to recognize revenue in financial statements. A good number of the questions are focused on identifying performance obligations contained in contracts with customers, which is the second step of the five-step method.

Sylvia Alicea, a professional accounting fellow at the SEC, said during a recent Deloitte/Bloomberg BNA conference that companies need to study all the relevant terms and conditions in a given contract because they may contain provisions that will be critical to the accounting conclusions. Termination clauses, repurchase rights, or put options, for example, could have a huge effect on determining what rights and obligations in a contract are enforceable, both for the registrant and its customer.

If a contract contains a right to terminate, that needs to be evaluated to determine whether it’s substantive, Alicea said, as it could affect the duration of the contract, which affects the accounting. Companies also need to carefully evaluate how substantive a given put option might be, as that could affect the determination of whether a given transaction is a lease or a sale.

And all of that brings accountants back to the less-than-precise answer that is a common theme in arriving at accounting conclusions under the new, principles-based requirements: Use your judgment. “Registrants should carefully assess the specific facts and circumstances of each transaction, including all relevant contractual terms, and exercise reasonable judgement when identifying and evaluating each contract with its customers,” Alicea said.

“Registrants should carefully assess the specific facts and circumstances of each transaction, including all relevant contractual terms, and exercise reasonable judgement when identifying and evaluating each contract with its customers.”
Sylvia Alicea, Professional Accounting Fellow, SEC

Eric Knachel, senior consultation partner on revenue recognition at Deloitte, says judgment is a big problem for a lot of companies. “The single biggest challenge of this standard across companies, in all industries, of all sizes, is balancing this notion of principles and judgment with consistency,” he said. “It’s not cookie-cutter. It’s not black-and-white. How do you balance these things that are somewhat at odds or somewhat contradictory?”

That’s the tall order companies must fill—and they only have a little more than six months to do so. More than three years after it was issued by the Financial Accounting Standards Board, the standard will finally take effect on Jan. 1, 2018.

At the recent conference, Alicea offered a little more advice to companies in the area of identifying performance obligations, but none of it is bright-line guidance that will tell companies exactly what to do. She referred instead to “important recurring takeaways” that companies might find helpful in identifying the unit of account.

For companies that are accustomed to the term “deliverable” under existing revenue recognition rules, be careful not to assume those are automatically “performance obligations” under the new standard, Alicea said. Every performance obligation requires a fresh look. In the specific fact patterns that have come to the attention of the OCA, “most of the registrants’ conclusions regarding performance obligations happened to be consistent with their conclusions regarding deliverables under existing revenue guidance,” she said, but that is not a given. Companies still have to do the analysis and document their conclusions.


The SEC’s Office of the Chief Accountant has offered its views on a number of additional technical questions regarding the new revenue recognition requirements, including:

The existence of a contract.  “…it would be inappropriate to account for a contract before the contract exists with both enforceable rights and obligations.” — Sylvia Alicea

Application of the contract combination guidance. “…the guidance in Topic 606 explicitly limits which contracts should be combined. In the consultation that OCA evaluated, the registrant had two contracts that were entered into at the same time and met some of the criteria for contract combination because they were: negotiated between all parties with a single commercial objective and were priced interdependently such that consideration paid under one contract was dependent on the price in the other contract. However, the contracts did not meet the requirement in Topic 606 to be with the same customer or related parties of the customer. Therefore, OCA objected to the registrant’s extension of the contract combination guidance beyond those parties.” — Sylvia Alicea speech

Application of the guidance on sales- and usage-based royalties. “The application of the guidance for royalties is based on when a report with the amount of revenues earned is received, not when the royalty sale or use occurred. The standard setters did not provide a lagged reporting exception with the new standard. Accordingly, I believe companies should apply the sales- and usage-based royalty guidance as specified in the new standard. The reporting, which may require estimation of royalty usage, should be supported by appropriate internal accounting controls.” — Wes Bricker speech

Application of the “impracticability” exception when a Form S-3 registration statement is filed after the first Form 10-Q reflecting adoption of the new revenue standard. “OCA is available for consultation if a registrant believes that, based on its facts and circumstances, a retrospective application of the new revenue recognition standard to all periods required to be presented in a Form S-3 is impracticable.” — Wes Bricker speech

Application of the principal and agent considerations for identifying the role of the reporting entity when another party is involved in a contract with a customer. “Particularly since the principal versus agent assessment is often fact-specific and judgment-based, I caution companies against any over-reliance on benchmarking to their peers' accounting policies. Benchmarking may be an element of, but is not a substitute for, management doing the work needed to support its own accounting policies, especially in this area.” — Wes Bricker speech
Sources: Sylvia Alicea; Wes Bricker

Alicea also addressed questions on whether promised goods and services could be regarded as a single performance obligation under the new requirements. Offering no straightforward yes or no, she pointed out the standard requires analysis of whether those promised goods and services are both capable of being distinct and are in fact distinct within the context of the contract. Companies need to do the analysis of whether the promised goods and services are inputs to a combined output, and the standard provides examples that are intended to illustrate how the principle works. Use your judgment, Alicea said.

Paul Vigil, senior director at BMC Software, said his team is working through when to identify separate performance obligations in a contract and when to combine them. Software companies commonly have complex arrangements with customers that can be hard to pick apart, even for purposes of current accounting requirements. Contracts typically involve the licensing of technology and a host of add-ons, like implementation, customization, upgrades, services, and support.

“As much as there might be gray areas today, those are increasing (under the new standard),” he said. “We need to work through it with our auditors and get comfortable. That’s a challenge for a lot of us. As accountants, we’re used to being able to give definitive answers that don’t change.”

Questions about whether to combine or separate performance obligations are important for companies to work out because the accounting effect of different determinations can be significant, said Knachel. It could lead to a difference in whether more revenue is recognized up front or over the life of a contract, which affects the timing of revenue. “I believe in the standard there tends to be a bias toward separating, but that’s my personal observation,” he said. “There could be instances where you do combine them. We’re seeing it as a challenging area.”

Companies also are struggling with determinations over when to recognize revenue at a point in time versus recognizing revenue over time, or over the life of an arrangement. The question surfaced recently at Johnson & Johnson when considering how to treat customized inventory, said Stephen Rivera, a senior director at the company. “If we’re customizing inventory for a customer and it can’t be resold, we might be recognizing inventory over time,” he said. That leads to analysis of the legal question of whether the company has a right to payment, said Knachel, pointing out the need to have legal counsel involved in the analysis.

In another technical conundrum of transitioning to new rules, companies are asking whether they’ll be allowed to apply the “residual method” to allocate a transaction price across performance obligations. That’s a method whereby companies might assign pricing to performance obligations that are easy to price and then allocate what’s left to something that’s more difficult to price on a stand-alone basis.

Vigil said he expects instances where the residual method will be applied, but Knachel said it will not be common. “The hurdle to get to the residual method is high,” he said. “I’m sure it will happen but I’ve yet to see a fact pattern where I’ve felt comfortable allowing the residual method.”