The other day Seamus Moran, our senior director of product management for Oracle Financials Cloud, remarked how ASC 606 and IFRS 15 require substantial changes to how organizations currently recognize revenue from customer contracts. This piqued my curiosity, so I asked Seamus to elaborate. Without hesitation, Seamus quickly explained the numerous impacts, devoting particular attention to the requirement for organizations to allocate the total contract amount to the contract’s performance obligations (aka goods or services to be delivered to customers).
This intrigued me because the allocation requirement seems straightforward: at contract inception, allocate the total customer contract amount (the transaction price) to the contract’s performance obligations based on the standalone selling prices (SSP) of the performance obligations (see an example from my colleague, Nigel Youell). Seamus concurred that allocations appear simple, but he noted that in many ways this is a reset from how organizations recognize revenue for customer contracts today.
One important change has to do with when allocations occur. With the new standard, companies must accrue liabilities for the performance obligations when the contract is first executed. This makes sense because companies now have a binding obligation to deliver goods and services. Seamus emphasized that this is a big change because today companies defer revenue by calculating and booking the liability when they issue the invoices.
Another significant impact occurs when companies do not have SSPs, such as when companies do not separately sell goods and services like “free” maintenance. In these cases companies can use judgment to estimate the selling prices (ESP). I asked Seamus if companies can use fair values to establish ESPs, and he said the standard doesn’t use fair value, but instead specifies “expected consideration”—that is, what companies estimate (expect) to receive in exchange for the goods or services. The boards initially considered fair value, but moved away from it following input from reviewers.
We then discussed the standard’s requirement for organizations to use the “relative SSP basis” to allocate the transaction price to the performance obligations. Seamus explained that this is necessary in any deal where prices are determined from the standalone prices. In all cases, companies must use proportions to allocate the transaction price. In cases where the deal total is different from the sum of the SSPs, that proportion will be more, or less, than 100%.
For example, if a contract is valued at $1,000 and the sum of the SSP’s is $1,150, the allocation percent would be 87% (1,000 divided by 1,150). This is an example of a customer receiving a contract discount. In other cases, where the deal total and the SSP total is the same, the proportion will be 100%. Say you just decide not to break out maintenance on an engineering sale, and sell a machine and maintenance for $100K, where the SSPs are $80K and $20K respectively. The proportions will be 100%, and the revenue values will be $80K and $20K, 100% of the SSPs.
Organizations must establish the accounting contract and the performance obligation (the unit of account). Then they simply allocate the deal price to the obligations by multiplying the SSP by the percent above. This establishes the value of the performance obligation both for accruing the obligation debt and recognizing revenue. The accrual happens when either party acts on the obligation. The difference between the billing value and the revenue value of each obligation will wash out to zero over the life of the contract, because the deal total (total billing) and the expected consideration (total revenue) have to be the same. So a group needs to record allocation discount assets and record allocation discount liabilities and track both to ensure that they eliminate by contract. With deferred revenue accounting, companies do not record any contract discounts, but companies track the inverse as carve-ins and carve-outs on invoices.
I asked Seamus whether there was anything else to consider regarding allocations. He noted that if the transaction price changes during the life of the contract, then companies must re-allocate using the same methodology. In contrast, with deferred revenue accounting, companies do not need to perform re-allocations. He further commented that organizations need to understand how to allocate variable amounts.We concluded that it is no trivial matter to uptake the new revenue recognition standard, and that the introduction of new technologies to support the new standards would greatly accelerate the transition. For a more in-depth look at this complex topic, we invite you to join Seamus for an upcoming Proformative webinar.