Question When Should Revenue Be Recognized

Question: When Should Revenue Be Recognized?

Answer: When it’s not collectible (maybe).

Historically it was always somewhat of a simple process to determine what was the amount of your company’s revenue. It was the top line of the income statement, regardless of whether it was called sales, net sales, revenue or some other similar caption. That amount represented the gross inflow of economic benefits during the period arising in the course of ordinary activities.(1) It was generally recognized based on two factors, (a) being realized or realizable and (b) being earned.(2)

Collectability refers to the customer’s credit risk and the ability to pay the entity the amount of promised consideration. Under the current revenue recognition model, collectability is a recognition issue where no revenue is recognized if collectability is not reasonably assured (ASC section 605-10-S99) or not probable (IAS 18.14(d)). Now within the convergence project on Revenue from Contracts with Customers, the FASB and IASB boards have been struggling with how an entity should account for uncertainty arising from the possibility that the customer may be unable to pay the consideration associated with a revenue contract. There are two general approaches in this area – an assessment of collectability could impact either the recognition of revenue or the measurement of the amount of revenue recognized.

If collectability is treated as a recognition issue, a minimum threshold (for example, probable or reasonably assured) must be met before any revenue is recognized. This approach results in a binary outcome – revenue is recognized if the threshold is met; no revenue is recognized if the threshold is not met. If collectability is treated as a measurement issue, the uncertainty about the customer’s ability to pay the consideration is reflected in the amount that is recognized as the transaction price. Under this approach the transaction price reflects the amount of consideration that the entity expects to receive.

The Original Exposure Draft Approach

In the original June 2010 exposure draft the boards proposed that entities should recognize revenue at the amount that the entity expects to receive from the customer. The approach that they took was that the measurement of the transaction price that would be allocated to the separate performance obligations would reflect an adjustment for collectability concerns. This initial adjustment for collectability would be part of the probability-weighted calculation of the transaction price resulting in a reduction in revenue for this initial collectability assessment.

After the initial calculation of the transaction price, once an entity had an unconditional right to consideration, the effects of changes in the assessment of customer credit risk would be recognized as income or expense rather than as revenue. The boards reasoned that once an entity satisfied a performance obligation, it had received an asset – the promise of payment / receivable. Thereafter, any reassessment of the customer’s credit status should be recognized as an impairment of the asset rather than a change in the amount of revenue previously recognized. This approach is similar to where non-cash consideration is received in a revenue transaction. The revenue recognized reflects the value of the non-cash consideration on the date the goods or services are transferred. Subsequent changes in the value of the asset do not affect the amount of revenue recognized.

This bifurcated approach resulted in a significant amount of remarks in comment letters from respondents to the original exposure draft. Under this proposed model, if the contract consideration was fully collected, this approach would have resulted in part of the collected amount being recorded in revenue and part of the collected amount being reported in other income based solely on the judgments made during the initial collectability assessment.

The Revised Exposure Draft Approach

When the revised exposure draft was issued in November 2011, the boards changed their approach to collectability. Under the revised exposure draft the boards proposed that: (3)

  1. Revenue should be recognized at the amount that the entity expects to be entitled;
  2. The requirements for the recognition of revenue should not include a specific threshold for expectations about the collectability of the promised consideration; and
  3. Any impairment losses (and reversals) should be presented as a separate line item adjacent to the revenue line item.

Under this revised approach, since the entity would be recognizing revenue for the amount to which they expected to be entitled, this revenue amount would not reflect any adjustments for amounts that the entity would not be able to collect from the customer. Revenue would therefore generally be measured at the gross amount invoiced. The revised approach also does not require an assessment of the customer’s ability to pay the contractual consideration as a pre-condition for recognizing revenue. One caveat to note is that in the Basis of Conclusion (BC34(b)) of the revised exposure draft the boards note that if there is significant doubt at contract inception about the collectability of consideration from the customer, that doubt may indicate that the parties are not committed to perform their respective obligations under the contract and thus the criterion for determining if a legally enforceable contract existing in order to account for a revenue contract under the exposure draft may not be met.

Since under this approach revenue would be recognized at the gross amount invoiced, any expected impairment losses due to collectability would be required to be shown in a “separate line adjacent to the revenue line item” so that the initial net income statement impact would equal the fair value reported for the associated asset / receivable.

What Does the Current Proposal Mean to You and Your Company?

Currently, collectability is handled through the recognition and measurement of revenue. If it is not reasonably assured or probable that the amount to be recognized as revenue is collectible, no revenue is recognized. The proposed requirements do not specify a threshold of collectability that must be passed before revenue can be recognized. Therefore, it is possible that revenue might be recognized earlier under the proposed model.

The current guidance in the revised exposure draft only notes that under the revised model these expected impairment losses would be recorded in a “separate line adjacent to the revenue line item”. Although there have been some public discussions of this area (including some by the “big four” accounting firms) where this line adjacent to the revenue line item is being described as contra revenue, the exposure draft guidance is not clear on whether this line is a reduction of top line revenue and this expected impairment loss line should be netted together with the top line revenue amount to arrive at a net revenue subtotal; or if this separate line adjacent to revenue line item would be considered to be a cost of sales line which would not reduce revenue but would only reduce gross margin. The boards have not published any public information which describes whether the top line revenue amount and the separate line adjacent to the revenue line item will need to be subtotaled to arrive at a net revenue amount.

Depending on how this classification of the impairment losses in the line adjacent to revenue is resolved when finalized by the boards, it is possible that going forward this collectability adjustment could reduce your company’s reported revenue. Under either a contra revenue or cost of sales scenario, the latest proposal from the boards will mean that for most entities your gross margin will decrease.

Under the current revenue accounting model most entities record a bad debt provision within selling, marketing and administrative expense (although a few may recognize it within other income / expense or cost of sales). Therefore, many entities will see their gross margin reduced to reflect their collectability assessment associated with revenue transactions.

(1) IAS 11 ¶7.
(2) CON 5 ¶83.
(3) Exposure Draft “Revenue from Contracts with Customers” November 2011, ED/2011/6 Basis for Conclusion BC165.

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