The Financial Accounting Standards Board (FASB) first introduced the Accounting Standards Update (ASU) 2014-09 in May 2014, which led to the establishment of the Accounting Standards Codification® (ASC) Topic 606, Revenue from Contracts with Customers (Topic 606).

A decade later, all companies reporting under generally accepted accounting principles (GAAP) are required to recognize revenue in accordance with Topic 606, including professional services companies. As a result, professional services companies must apply significant judgment to determine the timing and amount of revenue recognized from their contracts with customers.

Topic 606 contains extensive disclosures related to a company’s contracts with customers—both quantitative and qualitative. Successfully comply with Topic 606 with insights into its approach, considerations for first-time reporters, and the lessons learned since 2014.

Revenue Recognition: A Refresher

Prior to the adoption of Topic 606, recognition of revenue was generally based on when the risk of loss from the sale of goods or services was transferred to the customer. Topic 606 shifted revenue recognition to be based on the transfer of control over the goods or services to the customer. Specifically, revenue is recognized upon the transfer of the specified good(s) or service(s) to the customer in an amount the entity expects to be entitled to receive from the customer.

Topic 606 uses a five-step model to increase financial reporting comparability across industries, done so through the application of a uniform framework for revenue recognition. This process promotes consistency in revenue recognition across industries, providing clearer insights into financial performance.

The Five-Step Approach

1. Identify the contract(s) with a customer. Evaluate whether the agreement is legally enforceable and defines the rights and obligations of both parties.
2. Identify the performance obligation(s). A performance obligation represents a promise to transfer a distinct good or service to the customer.
3. Determine the transaction price. The transaction price is determined by considering fixed amounts, variable consideration—such as discounts, rebates, bonuses, and price concessions—noncash consideration, amounts paid or payable to the customer and whether the arrangement contains a significant financing component.
4. Allocate the transaction price to the performance obligation(s). Allocate the transaction price to the performance obligations based on their relative standalone selling prices.
5. Recognize revenue when or as the entity satisfies a performance obligation(s). Recognize revenue over time, if certain criteria are met, or at a point in time, as each performance obligation is satisfied, ensuring that the revenue reflects the transfer of control of goods or services to the customer.

Refer to our Revenue Recognition Guide

Considerations for First Time Compliance

For companies that will be reporting revenue in accordance with Topic 606 for the first time, the impact of the guidance is complex and expansive, involving many different functions within an organization.

Business areas that may be impacted include:

• Financial reporting
• Information systems
• Standard contracts and other sales agreements revisions
• Sales incentives and commissions
• Internal control processes
• Executive compensation arrangements
• Debt covenants
• Taxes

Every entity is affected differently, but in several situations, the standard may result in:

• More performance obligations—or separate accounting units—for bundled sales agreements
• Earlier revenue recognition
• Increased deferred costs to be amortized in the same periods that revenue is recognized
• Changes to internal controls, processes, and procedures
• Increased disclosures
• Additional judgement from management

These are generalizations—the exact effects of the new standard may differ for each individual business and should be carefully evaluated.

Implementation Timeline

There are four phases of implementation that professional services companies are likely to find helpful when adopting ASC Topic 606 for the first time.

Assessing Contract Types

The following is an overview of the most common types of contracts professional services companies use and how accounting for the associated revenue is conducted under Topic 606.

Fee-for-Service—Actual Time Incurred

These types of contracts are typically based on the actual time incurred on a project charged at one or more specified hourly rates.  These contracts can be short-term or extend over multiple reporting periods.

Key Considerations

• Topic 606 may not significantly impact the pattern of recognition for time and materials contracts.
• Revenue will be recognized over time as progress is made towards satisfaction of the performance obligation—if the benefits of the services provided to the customer are simultaneously delivered and consumed by the customer, the services create or enhance an asset—for example work in progress—that the customer controls, or the services create an asset with no alternative use and there is an enforceable right to payment for services completed to date.

Determining Performance Obligations

A performance obligation is a contractual promise to provide a good or service, or a bundle of goods or services, that is distinct. Careful consideration should also be given to a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. A promised good or service is capable of being distinct if the customer can benefit from it either on its own or with other readily available resources, and if the promise to transfer a good or service is distinct within the context of the contact.

To determine if a promise is distinct within the context of the contact, an entity should consider if the purpose of the promise is to transfer individual goods or services or a combined item for which individual goods or services are inputs. Factors that indicate two or more promises to transfer goods and services aren’t distinct within the context of the contract include, but aren’t limited to:

• Significant integration service is provided that results in a combined output
• One or more of the goods or services significantly modifies or customizes another good or service in the contract
• The goods or services are highly interdependent or highly interrelated

Allocating the Transaction Price

If there’s more than one performance obligation, the transaction price is allocated to each performance obligation based on the relative standalone selling price at contract inception.

However, if a particular performance obligation isn’t sold on a standalone basis or if the standalone selling price isn’t directly observable, the standalone selling price will need to be estimated. If pricing for the performance obligation isn’t highly variable or uncertain, the standard states the following two techniques may be used to estimate the standalone selling price:

• The top-down approach—or adjusted market assessment—which considers competitor pricing and market positioning
• The bottom-up approach—or expected cost plus margin—which estimates costs to provide a good or service and adds a reasonable margin for production and selling efforts

If pricing for the performance obligation is highly variable or uncertain, the standard allows for the residual approach to be used in select circumstances, where the observable standalone selling prices are deducted from the total transaction price to estimate the standalone selling prices of the remaining goods or services. The amount allocated under this method must still reflect the consideration to which a company expects to be entitled in exchange for a good or service.

Standalone Selling Price

The process for allocating the transaction price to the distinct performance obligations is based on a relative standalone selling price approach.

Key Considerations

Determining a standalone selling price can be straightforward if the company routinely sells the good(s) or service(s) on a standalone basis. However, if not, then an entity will have to estimate the standalone selling price using one of the three methods, as shown in the chart below. 

These methods are described in detail on page 23 of our Revenue Recognition Guide.

Approach

Fee for Service—Fixed Fee

A contract that’s based on a predetermined, set dollar amount is a fixed-fee agreement.

Key Considerations

• A customer may pay one fee, but there could still be multiple separate performance obligations within the contract.
• Revenue may be recognized over time or at a point in time, depending on the terms of the arrangement.
• Consideration is required to determine if services are distinct or bundled

Performance Obligations Under Fixed Fee Contracts

Similar to the “actual time incurred” contracts discussed above, the number of performance obligations within fixed-fee contracts also needs to be determined. There may be more than one, even if the customer pays a single fee.

Revenue Recognition

Revenue should be recognized when the performance obligation is satisfied by transferring to the customer the promised good(s) or service(s). Revenue may be recognized over time or at a point in time, depending on when the customer obtains control of the good(s) or service(s). Control is generally deemed to be transferred over time when:

• The customer simultaneously receives and consumes the benefits provided by a company as it performs them
• The company’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced
• The company’s performance doesn’t create an asset with an alternative use to the company and the company has an enforceable right to payment for performance completed to date

If none of the above criteria are met, control would be deemed to be transferred at a point in time.

Companies need to consider all relevant facts and circumstances when determining when control is transferred to the customer, and the pattern of revenue recognition needs to be determined at contract inception.

Principal–Agent

If a contract involves more than one party providing goods or services to a customer, it’s likely to require further evaluation of the specific circumstances in order to determine whether the company is a principal or an agent as this will determine if revenue should be presented gross or net.

Key Considerations

The accounting treatment for such contracts focuses on the concept of control, which is explained in the table below.

Approach

• Establish who controls the good or service. The entity that provides the service or controls the good before that service or good is transferred to the customer is considered the principal and may have the following characteristics: It’s primarily responsible for fulfilling the promise to provide the specified good or service, has inventory risk before the specified good or service has been transferred to a customer or after transfer of control to the customer, and has the discretion and ability to establish the price for the specified good or service.
• Identify separate performance obligations. Principal–agent contracts can contain more than one specified good or service, and there can be principal and agent performance obligations within the same contract.
• Recognize revenue when a performance obligation is satisfied. This is true for principal and agent arrangements; however, an entity that is determined to be the principal must recognize revenue in the gross amount of consideration to which it expects to be entitled in exchange for the specified good or service transferred (gross). An entity that is determined to be the agent must recognize revenue in the amount of any fee or commission to which it expects to be entitled in exchange for arranging for the specified good(s) or services(s) to be provided by the other party (net).

Other Considerations

When determining whether a revenue stream requires a technical assessment, it’s necessary to consider the following.

Variable Consideration

Under Topic 606, variable consideration—such as an incentive, bonus, rebate, or discount—that’s promised within a contract must be considered when determining the transaction price.

Variable consideration should be determined using either the best estimate or expected value approach, whichever method is expected to better predict the amount of consideration to which an entity will be entitled. However, variable consideration should only be included in the transaction price if it’s probable a significant revenue reversal won’t occur.

As a result, some entities may recognize variable consideration sooner under Topic 606 than under prior GAAP.

Key Considerations

• An entity should estimate the amount of variable consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer. This amount should be reevaluated and updated as necessary during each reporting period over the course of the contract as better estimates become available.
• If it’s probable there will be a significant reversal, variable consideration should be constrained such that the amount of the probable significant reversal is not included in the transaction price. The determination of “significant” is in relation to the underlying contract and not to the entity’s total revenue and the analysis includes assessing both the likelihood and magnitude of a potential revenue reversal.
• Losses that may result from credit risk shouldn’t be considered when estimating or determining the transaction price.

Approach

• Identify variable consideration. Variable consideration can be explicitly stated in a contract or implied.
• Apply either the expected value method or most likely amount method. The expected value is the sum of probability-weighed amounts in a range of possible amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.

The most likely amount is the single-most likely amount in a range of possible amounts. This means it’s the single most likely outcome of the contract. The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes.

Contract Modifications

Management will also need a process to evaluate and document significant contract modifications. A contract modification is an approved change in the scope or price of a contract that creates new enforceable rights and obligations or changes the existing enforceable rights and obligations. Contract modifications are often referred to and executed as amendments or change orders and may be implied by customary business practices or approved orally or in writing – the key is whether it is legally enforceable.

In some cases, the modification will be treated as a separate contract and won’t affect revenue recognized on the original contract in any way. In other situations, a company will be required to treat a contract modification as a termination of the existing contract and the creation of a new replacement contract. In still other cases, a company will account for a contract modification by recording a catch-up journal entry to adjust the cumulative revenue recognized to date on the contract. The ultimate accounting treatment will depend on the nature of the modification.

Key Considerations

• A contract modification should be accounted for as a separate contract if the scope of the contract increases due to additional distinct good or services and if the price of the contract increases by an amount that reflects the standalone selling prices of the additional promised goods or services.
• If the modification is treated as a separate contract, it won’t impact revenue recognition on the original contract.
• A separate contract will require separate accounting allocation of costs, billings, and revenue recognition.
• If a contract modification doesn’t meet the criteria to be accounted for as a separate contract, the modification will result in being accounted for as either a termination of the original contract and the creation of a new contract, or as if the modification were part of the existing contract. Accounting as a termination of the existing contract and creation of a new contract occurs if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. If the remaining goods and services aren’t distinct from the goods or services transferred on or before the date of the contract modification, the modification should be accounted for as if it were part of the original contract.

Approach

• Consider whether the contract modification has been approved by all parties.
• Determine if the contract modification adds additional distinct good(s) or service(s).
• Determine accounting treatment based on whether the contract price is derived from stand-alone selling prices for the additional good(s) or service(s).

Capitalization of Costs

Incremental costs of obtaining a contract with a customer within the scope of Topic 606 are deferred and recognized as an asset if the entity expects to recover the costs under ASC Subtopic 340-40, Other Assets and Deferred Costs: Contracts with Customers (Subtopic 340-40).

Key Considerations

• Under Topic 606 and Subtopic 340-40, companies aren’t permitted to make an accounting election to capitalize or expense costs incurred to obtain a contract; however, a company may elect an accounting policy to immediately expense all such costs when the amortization period would be one year or less.
• Incremental costs of obtaining a contract are those costs an entity incurs to obtain a contract with a customer it wouldn’t have incurred if the contract hadn’t been obtained—such as sales commission.
• Any deferred costs are amortized over the life of the contact—including anticipated renewals as applicable—in the same pattern as revenue is recognized.
• Prior to settlement, companies will continue to recognize liabilities for incremental costs as they are incurred in accordance with applicable liability guidance.

Approach

• Recognize an impairment loss in earnings if the carrying amount of an asset exceeds its recoverable amount. Under Subtopic 340-40, the recoverable amount equals the consideration the entity either expects to receive in the future or has received—but hasn’t yet recognized as revenue—minus the costs directly related to providing goods or services that haven’t been expensed.
• Consider the anticipated contract renewal and amendments when determining the amortization period. If there’s ongoing compensation or other expenses based on contract renewals—but not based on the initial contract—it may be necessary to consider if the amortization period should exceed the initial contract period.

Lessons Learned

Whether you are complying with GAAP for the first time or have been doing so for years, here are a few matters that companies should consider as they report revenue in accordance with Topic 606.

Accelerated Revenue Recognition

Companies may note an acceleration of revenue recognition under Topic 606, particularly firms that previously recognized revenue based on time billed. Under Topic 606, revenue is typically recognized when the service is provided—time incurred—versus when the invoice is sent to the client.

Tax Reporting Impact

Companies also must assess the impact of recognizing revenue in accordance with Topic 606 as compared to their tax reporting, both from a compliance side as well as financial statement reporting of income taxes in accordance with ASC Topic 740:

• Typically, revenue recognition for tax follows book revenue, so an acceleration in recognizing revenue for financial reporting purposes could have a similar impact on revenue for tax reporting purposes.
• Variable consideration recognized for financial reporting will need to be assessed to determine if it meets the thresholds for recognizing revenue for income tax – if revenue passes the all-events test or falls into an exception.
• There will likely be the requirement to file a methods change for federal income tax filing.

Cost to Obtain Contracts

A surprising challenge of Topic 606 is the applicable requirements of Subtopic 340-40. Many companies may be caught off guard by the numerous types of compensation arrangements that are scoped into Subtopic 340-40 and require companies to capitalize certain costs.

Companies must thoroughly evaluate compensation agreements, aside from commission arrangements, to determine if any revenue driven bonuses, stock compensation, or fringe benefits will be required to be capitalized. This can also span beyond the standard sales team to include members of management if compensation is structured around revenue.

Additionally, determining the useful life can be a complex exercise, requiring much judgement. This may be especially difficult if there’s minimal historical customer turnover due to the nature of the business.

• A renewal, or renewal option, within the context of Topic 606, might differ from the general understanding of a renewal. Companies may interpret or classify a repeat customer continuing or expanding the services as a renewal customer, however, within the purview of Topic 606 this may be considered a new contract.
• There may be a distinction between customer life and contract life, that should be evaluated separately. This could impact the determination of the useful life for purposes of amortization. In many scenarios, the useful life of the capitalized asset could be shorter than the customer life.

We’re Here to Help

For more information on how Topic 606 may affect your business, or if you’d like help implementing the standard, contact your Moss Adams professional.

Additional Resources

• Professional Services Practice
• Financial Statement Audits Services