Archive for June, 2015

Road to Revenue, Our Third Stop – The Transaction Price

We’ve covered quite a bit of ground on our journey thus far. At our first stop we determined whether we have a contract with a customer, we learned what a contract was and what a customer was. At our second stop we figured out exactly what we have agreed to deliver to our customer as part of this contract. After a short break, we traveled a bit farther and came to our third stop. Here’s where we will consider the “fun” part, what we will be paid, the “transaction price”.

So, what exactly is the “transaction price”? Our authoritative guidance, the ASC 606 – Revenue from Contracts with Customers (“ASC 606”) tells us that the transaction price is “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer”. The transaction price then, is what we will receive, typically cash, in exchange for the goods or services that we deliver to our customer. Seems pretty simple, doesn’t it? In most instances that will be the case, the transaction price will be clearly spelled out in the contract. Often it will be fixed and will be easy to figure out. In other cases the transaction price will be much more complex. In some of these cases, all or a part of our price may vary depending upon our performance, the customers use of what we’ve delivered to them, or something else, this is what we call variable consideration. In some other cases the customer may be paying us over an extended period of time, this type of consideration then includes a significant financing component which we will need to consider in our price. Still in other cases we may agree to accept something other than cash in exchange for what we provide to the customer, this is what we call the noncash consideration. A fourth case to consider is when we offer our customer a discount on the sales price in order to entice them to purchase your product or service. All of these will add some level of complexity to our analysis of our transaction price. Here are some things to think about:

  • Variable Price Components If our price or part of our price to our customer will vary, it may be difficult to fully calculate the total transaction price because we may not know the value of this variable component when we enter into our agreement. What we would do in this case is estimate the variable portion of our price by either using the weighted average of the range of possible prices or use the amount that is most likely to be the case. This will take some judgement on our part and will require us to have processes and systems in place to monitor the variable components of our price so that we can adjust it as needed to reflect the final actual price. This is a change to how we currently look at transaction prices. Under our current guidance we can only consider those fees that are fixed or determinable/certain in coming up with our total revenue, that is our transaction price. Under this new guidance we will be able to include the uncertain, but estimable, variable component of our price in our total revenue.
  • Financing Customer’s Purchases There may be cases where we decide to allow our customer to pay over a period of time that is more than one year. We will need to take into consideration that part of the transaction price will include a financing component similar to an interest rate charged on a loan. This “interest” component with then become part of our transaction price.
  • Noncash Components What if part of what we receive from our customer is goods or services, “noncash”? In this case we would follow current guidance and measure that part of our consideration based upon its fair value.
  • Customer Discounts If we offer to pay something back to our customer and they are not required to provide a good or service in exchange for this payment, then in fact we are providing a discount to our customer that would go towards reducing the total transaction price.

What it comes down to is our transaction price is the total of everything that we expect to receive from your customer in exchange for the goods or services that we will be delivering to them. Our transaction price may be fixed and simply stated in the contract, or it may be a combination of a fixed price plus one or more of the other types of consideration as we discussed above. Just like we did with performance obligations, we will take stock of all of the types of consideration we expect to receive from our customer as a result of delivering to them the goods or services we agreed to, this is our transaction price.

Thank you for traveling down the revenue recognition road with me to our third stop. At our stop we will be tackling a complex, but intriguing, subject, allocation our transaction price between our performance obligations. Stay tuned!

Please feel free to comment on my post or reach out to me with any comments or questions you may have.

 

Susan Nieland, CPA

My Website

My CFO Solutions Blog

 

 

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Road to Revenue, Our Second Stop – Performance Obligations?

The second stop on our journey to revenue recognition is to determine what we are required to do for our customer, our performance obligations. This is an important stop for us. This is the this stop where we identify what we need to do in order to earn revenue from the customer. We will start with the technical definition based upon our authoritative guidance (the ASC 606 – Revenue from Contracts with Customers, “ASC 606”, that is) first, and then break it down and simplify it. Let’s go! The ASC 606 defines a performance obligation to be “a promise in a contract with a customer to transfer either a good or service that is distinct or a series of goods or services that are substantially the same to the customer”. The thing to remember here is that we may have more than one type of good or service that will be transferred to our customer as part of our agreement with them. Each distinct (that is different) type of good or service that is transferred to the customer as part of our agreement is its own performance obligation. What we need to do now is identify each of the different types of goods and/or services that we are delivering to our customer (our performance obligations). Let’s take a look at a few examples.

Example 1 – Simple Retail Sale

Let’s say you are a designer jeans retail store. You purchase your inventory of designer jeans from your favorite wholesaler, price them (with your customary markup), and put them on the display shelves to sell to customers. Your ordinary course of business, the reason you exist, is to sell designer jeans at a profit. In this example, your performance obligation is to deliver designer jeans to customers.

Example 2 – Continuous Delivery & Receipt

In this example, you are a cell phone provider. You enter into a contract with your customer to provide cell phone service for two years and agree to deliver and charge your customer for this service monthly. In this example your performance obligation is 24 months of uninterrupted cell phone service. Although you have 24 months of service to deliver, they are all pretty much the same service rather than separate, distinctly different services. In this case you have a series of distinct services that are, for all intents and purposes, the same service (cell phone service) delivered to the customer the same pattern (monthly). This series of 24 months of cell phone service is therefore considered one performance obligation.

Example 3 – Multiple Deliverables

This time you are a software company that has developed a unique software solution for companies to help them manage their data centers more efficiently. You sign contracts with your customers to provide them with the software and install the software on their servers. In addition, you provide a one-year warranty to your customer and also sign them up for one year of software maintenance which includes upgrades. This case is not as straightforward as the previous two examples, although there could be more complexities, for illustration purposes, we’ll keep it simple. In these types of instances I would highly recommend working closely with your CPA to ensure proper revenue recognition. By way of example, we’ll say that we’ve got four distinct goods and services to provide to our customer, the software, professional services to install the software, warranty on the software and the one-year maintenance services. Each of these services/goods is different and distinct from the other. This is probably the most complex and difficult type of contract to have to deal with, but it is also not uncommon.

When you are thinking about what your performance obligations are, just simply think about what it is you’ve agreed to provide to your customer. Take an inventory, a simple list, of what you have agreed to sell to your customer, including the services that you have agreed to provide, which could be outside the written contract, but are part of your customary practices. Group the goods/services together that are similar, then separate the remaining goods and services into their distinct deliverables. You have now identified your performance obligations.

Thank you for traveling down the revenue recognition road with me again to our second stop. Please feel free to comment on my post or reach out to me with any comments or questions you may have.

Susan Nieland, CPA

My Website

My CFO Solutions Blog

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Driving the Revenue Road – What is a Contract?

In my previous post, we looked at What is Revenue? and determined that revenue is earned as a result of performing our primary business activity. That activity could be anything from selling cars to selling software to providing consulting services or providing healthcare services. Now that we have an idea of what revenue is, how do we go about recognizing it?

There are many different ways of recognizing revenue and there is specific guidance from the FASB (the chief accounting rule setting body) on certain types of revenue (interest income, investment gains and revenue earned from leases, to name a few). These we will steer away from, in this discussion, as these are excluded from the scope of ASC 606 – Revenue from Contracts with Customers (ASC 606). We will steer into the lane related to revenue earned as a result of entering into contracts with customers.

We have 5 stops along our journey to revenue. The first stop on our journey will be to determine whether we have a contract with a customer. Once we get through that stop, we’ll venture on to our second stop, identifying what we are obligated to do for the customer under the terms of the contract (our performance obligations). After this stop, we’ll take a slight break before proceeding on to our third stop, at which point we’ll figure out what the sales price is (transaction price). At the next stop we’ll divide the sales price between the different performance obligations that we identified on our second stop (allocate the price). Once we’ve gotten through this stop, we’ll venture on to our final desitination, which is where we recognize revenue. By now you are probably scatching your head wondering what this means and why should you care, right? My goal in this post, and future posts, is to de-mystify all of the revenue recognition guidance and help you understand it better and it’s implications for your business. By doing this, you’ll have clear insight into the revenue driven by your business and will be able to grow and prosper.

What does it mean to have a contract with a customer?
Let’s look at each part separately first, then bring them back together at the end.

Merriam-Webster defines a contract as “a binding agreement between two or more persons or parties” one that “legally enforceable” or “a business arrangement for the supply of goods or services at a fixed price”. ASC 606 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations”, further “contracts can be written, oral, or implied by the entity’s customary business practices”. You have a contract with someone (whether that someone is a person or business entity) regardless if it’s a 200 page document that took months and room full of lawyers to craft and agree to or if it’s something you verbally told someone you’d do and they agreed to pay you for.

Now that we get what a contract is, what is a customer? That’s easy. Isn’t it? When we turn to Merriam-Webster, we find that a customer is “someone who buys goods or services from a business”. The ASC 606 has a very similar definition of customer, “a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration”. Boiled down, a customer is someone that purchases goods or services that we produce in the ordinary course of our business (the reason we’re in existance), whether that customer is someone that walks into our store off of the street an buys a pair of jeans off the shelf, or a multi-million dollar business that contracts with us to perform specialized consulting services. It usually is pretty easy to determine if you’ve got a customer/vendor relationship going, but there are times when this is not clear. This is when expert advice may be needed.

Now that we are clear on what a contract is and who our customer is, let’s put them together and see what we get. For the most part, we get a contract with a customer. Most contracts with customers will be easy to identify and straight forward while others may require some digging and analysis to fully understand. In quite a few cases, these contracts will be very easy to identify as they will be lengthy documents that will have been negotiated and agreed to between ourselves and our customer, but some customer contracts may not be readily disernable. Say your customer comes into your store and picks a pair of jeans off of the shelf and buys them, you have just entered into, executed and completed a contract for the sale of the jeans to your customer. On the other hand, your customer may call you to engage your services in implementing your specialized computer software package, you negotiate the sales price and terms of delivering the software and an annual maintenance agreement as well as a team to implement the software for the client, you’ve just entered into a contract with your customer. That being said, there is one more element that we need to discuss which is a key criteria for having a contract with a customer. That is, according to ASC 606, the customer must be ready, willing and able to pay the agreed to price. You must be fairly certain that you’ll receive the sales price. If not, you don’t have a contract with your customer.

Thank you for going down the road to revenue with me to this first stop. Identifying customers and contracts with customers is often more complex than what we’ve just gone through, if you find yourself in a complex situation please contact your CPA for advise. Feel free to reach out to the author for guidance and assistance, that’s what I’m here for.

 

Susan Nieland, CPA

www.cfo2u.com

 

 

 

 

 

 

 

 

 

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