I’ve just finished reading the IASB/FASB exposure draft on revenue recognition, and I have all kinds of questions running through my head. But before I get to those questions, let me first say that I am very impressed with this document. In fewer than 90 paragraphs of guidance (ignoring application guidance), the IASB/FASB have laid out a standard that will effectively replace a large swath of US GAAP (that is often confusing and contradictory) and two vacuous IASB standards on revenue recognition. I commend the staff and boards for putting together what I think will function as a practical, cost-effective, and principled standard for recognizing revenue–at least when there are contracts with customers.

Of course, with such a significant change, there are bound to be questions and concerns. Here are a few that have occurred to me.

  1. One of the debates we had in the early days of this project was whether to define revenue, or just address how revenue should be recognized. As this exposure draft makes clear (see paragraphs 1-2), the boards ultimately decided not to define revenue, but instead only to address when revenue is recognized in contracts with customers. This made me wonder whether the boards will be happy with revenue being recognized in the absence of contracts with customers. Does revenue recognition require a customer? Apparently not. Revenue is recognized today for changes in the value of some mineral, biological or agricultural assets (IAS 41), even in the absence of a contract with customers. Why do we get a difference for revenue recognition principles across various industries or types of assets? The proposed new standard scopes out non-contractual situations (such as biological and agricultural assets) as well as contractual situations (such as leases, insurance, financial instruments, and guarantees). Conspicuously absent from the exposure draft is any rationale for scoping these areas out of the proposed standard. From experience working on this project, I’m guessing that’s because there was no general agreement about WHY these would be scoped out. There is simply a consensus that they should be scoped out. Wouldn’t it be great if the boards could provide some rationale for scoping out particular types of transactions?
  2. The exposure draft states that an entity shall account for each promised good or service as a separate performance obligation only if that good or service is distinct (see paragraph 22). A good or service is distinct if either (a) an entity  sells an identical or similar good or service separately, or (b) the entity could sell the good or service separately because (i) it has a distinct function AND (ii) it has a distinct profit margin. My question–how do you know whether something has a distinct profit margin unless you (or someone else) actually sell that something separately? And if you already sell it separately, then there’s no need for condition (b). The exposure draft states that a distinct profit margin exists if that good or service is subject to distinct risks and the entity can separately identify the resources needed to provide the good or service. This is one area of the proposed new standard that I think people may have some difficulty with—determining whether a potentially separate good or service has distinct risks. If there’s anything our recent past has taught us, it’s that people are pretty bad at identifying and quantifying risks. Who knows, perhaps it won’t be so hard to do for revenue recognition purposes! (By the way, don’t misinterpret my tone here…I actually like the direction the boards have gone with this guidance, but I think it will be a little perplexing at first.)
  3. Determining the transaction price in a contract receives lots of attention in the exposure draft. The boards decided that the transaction price should be adjusted based on the time value of money (if financing is a significant component of the arrangement), customer creditworthiness, collectibility, any non-cash consideration received from the customer, and any consideration payable to the customer (such as rebates). I don’t really have a question here, but I do want to highlight how this will be a significant departure from past practice in some situations. Previously, revenue would not be recognized in some situations if certain criteria were not met, for example in real estate sales. If the criteria were met, revenue for the full contract amount would be recognized. Instead of asking whether to recognize revenue, this standard moves more toward asking how much revenue to recognize. So, for instance, if you have sufficient history selling real estate to particular classes of customers, and your history suggests to you that 60% of the time customers follow through with their promises to pay over time, then either through discounting with a high interest rate or through an adjustment due to collectibility, you would recognize the sale of real estate at a drastically reduced amount. Any amount received beyond the original revenue recognized would be treated as a gain or loss. Personally, I think this is an improvement over the criteria approach, but it has its own problems as well, including the estimation process required to determine the amount of revenue to recognize in such a sale.

I’ll stop here for now. I still want to go through the application guidance with a finer tooth comb, but I’m pretty impressed with most of what I’ve read. As much as the project was originally conceived to be a general standard on revenue to replace all other revenue standards, I think the boards have appropriately scaled back their ambitions to focus strictly on settings where a contract with a customer exists. This represents the lion’s share of situations in which revenue is recognized today, and the proposed new guidance will not change most accounting out there. However, what it does change could be pretty significant—including construction contracts, real estate sales, and software revenue recognition. I look forward to reading the comment letters over the next few months!