The new principles-based revenue recognition model introduced in Accounting Standards Codification 606 (ASC 606) is already in effect for much of the business world. Publicly traded companies were required to implement the new accounting standard for reporting periods that began on or after December 15 of 2017, but nonprofits were given an additional year to comply. With 2018 behind us, this implementation deadline is fast approaching. The principles in the new standard are complex and nuanced, and you may have to dramatically alter your accounting practices.
The Five-Step Model for Nonprofits
The centerpiece of the new revenue recognition standard is the five-step model. Before recording contract revenue, you must do each of the following:
- Identify the contract with the customer.
- Identify the separate performance obligations.
- Determine the transaction price.
- Allocate the transaction price among the performance obligations.
- Recognize revenue when (or as) the performance obligations are satisfied.
The model appears simple and straightforward at first glance, but you can experience hiccups during each step of the process.
STEP 1: IDENTIFY CONTRACTS WITH CUSTOMERS
The first step, which you may assume is the simplest, can be a sticking point. You must first identify what revenue sources will fall under the purview of this five-step model. Not all will. ASC 606’s full title is Revenue from Contracts with Customers, and as the name suggests, it only applies to revenue resulting from contracts. In order for there to be an explicit or implied contract, an exchange of goods or services must occur. This transaction is typically called an “exchange transaction.” Let’s look at a few common nonprofit revenue streams to see if there is an exchange transaction:
- Contributions — A nonprofit does not typically provide a donor with benefits in return for a contribution. There is no exchange transaction, so ASC 606 does not apply.
- Grants — Grants may be considered a contribution if the nonprofit provides no benefit in return, but otherwise they may fall under ASC 606’s guidelines. For instance, if the nonprofit provides a service directly to the granting entity in exchange for the grant, then this is considered contract revenue and the revenue recognition standard will rule.
- Sponsorships — Sponsorships may fall in the domain of ASC 606 if the nonprofit provides a benefit in return for the sponsorship — say, tickets to the next fundraising event, or two free memberships to the sponsoring entity.
If you find this step a bit ambiguous, you’re not alone. The Financial Accounting Standards Board recently released an Accounting Standards Update that clarifies the scope of ASC 606 for nonprofits.
STEP 2: IDENTIFY THE SEPARATE PERFORMANCE OBLIGATIONS
A performance obligation can be described as a separate and distinct promise in the contract. A single contract could have only one performance obligation, or it may have more. Take, for instance, a museum that sells a $500 annual membership to one of its supporters. In return for the membership fee, the museum promises to provide to the donor (1) admission into the museum, (2) a discount at the gift shop, and (3) a reservation at their annual fundraising dinner. This single membership sale comprises three separate and distinct performance obligations.
STEP 3: DETERMINE THE TRANSACTION PRICE
The next step is to determine the price of the contract itself. In the museum example above, it’s easy to assume that the transaction price is $500 — after all, that’s what the membership costs. Unfortunately, it’s not always that simple. If the value of admission, the gift shop discount, and the fundraising dinner total less than $500, then the contract price cannot be the full $500. Any amount above the true transaction price would be considered contribution revenue and would be accounted for outside of ASC 606.
STEP 4: ALLOCATE THE TRANSACTION PRICE
Once you’ve determined the transaction price, you must allocate it among the performance obligations. The easiest way to do this is to determine what the standalone price of each performance obligation would be if it were sold separately. This determination may require some assumptions and judgments on your part, which should be recorded and disclosed in the notes to the financials (more on this later).
STEP 5: RECOGNIZE REVENUE AS PERFORMANCE OBLIGATIONS ARE SATISFIED
In the final step, you record the revenue. Nonprofits will recognize the revenue when (or as) they fulfill their promises. For some contracts, this means the revenue will be recognized at one point in time (e.g., a college application fee would be recognized once the withdrawal period had passed). For others, this means the revenue will be recognized over a period of time (e.g., a contract to provide discounted housing for needy families would be recognized as ratable over the rental period).
This five-step model will require nonprofits to think about their business differently, and the compliance complexities may encourage some to simplify their processes. For example, your nonprofit might determine that it’s easier to recognize revenue under this five-step process when your patrons’ membership dues are renewed at the same time every year — perhaps at the beginning of your fiscal year. Renewing each patron’s membership at their anniversary date could be an administrative burden you’re unwilling to take on.
Disclosure Requirements for Nonprofits
In addition to the five-step revenue recognition framework, the new accounting standard will also require specific disclosures on financial statements. These disclosures are both qualitative and quantitative. For example, you may need to disclose:
- When your contracts become nonrefundable;
- What benefits you provide to your donors that are incidental and therefore not tracked as a benefit received in a contract (e.g., a T-shirt received at a fundraising event);
- How impairment to a contract receivable will be measured;
- Assumptions you’ve made in estimating conditional revenues;
- Information about contract assets and the collectability expected from those contracts;
- Judgments you made when bifurcating the agreement into contract and non-contract (i.e., contribution) components; or,
- Assumptions you’ve made when determining the fair value of performance obligations.
Time Is Running Out
Nonprofits must be in compliance with ASC 606 on their first reporting period that begins after December 15 of this year. For calendar-year entities, this deadline is fast approaching, and fiscal-year entities don’t have much longer.
Now is the time to get serious about these requirements. Sit down and go through your revenue streams with a critical eye — which ones are exchange transactions? Which ones are true contributions? It may take some time, but it’s best to put in the effort rather than discover your mistakes during the annual audit. The bottom line is that your financial statements tell a story, and you want the story to be accurate. These revenue recognition changes can help you tell that story. And as always, talk to your CRI accountants if you’re not sure where to begin.