The amount of revenue and support reported by a nonprofit organization is one of the most significant metrics in the financial reporting process. The Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) that is effective soon which provides new guidelines for the recognition of revenue by nonprofit organizations that issue financial statements in conformity with U.S. generally accepted accounting principles (GAAP).
In 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. For most nonprofit organizations, the ASU is effective for annual financial statements issued for fiscal years beginning after December 15, 2018 (i.e., calendar years ending December 31, 2019 and non-calendar years ending in 2020).
Key Point
The ASU applies to revenue from contracts with customers, commonly referred to as “exchange transactions” (i.e., reciprocal transfers in which each party receives and sacrifices approximately commensurate value). The ASU does not apply to contributions (i.e., unconditional and nonreciprocal transfers of assets).
Five-Step Model to Revenue Recognition
The ASU is principles-based. The core principle of the new guidance is that an organization should recognize revenue “to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” In other words, the amount and timing of revenue recognized by an organization in its financial statements should be a reasonable and fair representation of the amount which will ultimately be paid to the organization as goods or services are rendered.
How does an organization go about implementing the new guidance? The ASU is centered on the following Five-Step Model:
Step 1: Identify the Contract with a Customer
Step 2: Identify the Performance Obligations in the Contract
Step 3: Determine the Transaction Price
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation
Let’s take a closer look at each step.
Step 1: Identify the Contract with a Customer
As you apply the ASU to your organization, the first thing to remember is that the ASU applies when revenue is connected to a contract. A contract is an agreement between two or more parties that creates enforceable rights and obligations. (Common examples for nonprofit organizations include membership dues, subscriptions, and tuition). A contract can be either written or (less commonly) verbal.
Step 2: Identify the Performance Obligations in the Contract
A performance obligation is a promise in the contract with a customer to transfer a good or service to the customer. It is what your organization is obligated to do for the customer. It is important to properly determine a contract’s performance obligations (unless a performance obligation is insignificant to the overall contract), since they ultimately drive the recognition of revenue discussed in Step 5. A contract may have only one performance obligation, or it may have multiple performance obligations.
If there is more than one performance obligation, only distinct performance obligations (those that can benefit the customer on their own) should be treated separately when recognizing revenue. An example of multiple performance obligations in a contract may include various benefits provided to a member in exchange for annual dues paid to an association.
Step 3: Determine the Transaction Price
The transaction price is the amount the organization expects to be paid in exchange for providing goods or services to the customer. When a contract clearly states a price for a single performance obligation, this step should not be complicated. However, nuances may exist. For example, there may be an embedded contribution in a contract (such as a sponsorship arrangement for which a benefit is provided to the sponsor) which should be accounted for outside of the ASU. Or, there may be variations in transaction price due to, for example, incentives, refunds, or discounts. The presence of such variations can complicate determining the transaction price and should be analyzed carefully.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
If there is more than one performance obligation identified in Step 2, the organization needs to determine the amount of the transaction price to allocate to each performance obligation. This step will likely involve judgment, because the standalone selling price (i.e. the price of a good or service sold separately) of distinct goods and services must be determined. The transaction price is then allocated to each performance obligation based on relative standalone selling prices. If there is no standalone selling price for a performance obligation, it must be estimated.
If there is only one performance obligation, this step is straightforward…the entire transaction price is allocated to the single performance obligation.
Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation
This is the final step in the process. Revenue is recognized as the organization satisfies its obligations under the contract by transferring the goods or services promised to the customer in the contract (i.e. the customer obtains control over the good or service). This transfer of control could occur over time or at a specific point in time.
Example – Educational Organization
Tuition and fees of educational organizations is one of the most common examples of revenue covered by the ASU in the nonprofit sector. This example walks through the Five-Step Model for Revenue Recognition for a primary and secondary educational organization which does not offer housing to its students. It is important to note that this example is not intended to be comprehensive, and there may be nuances to an educational organization’s contractual arrangements with its students that should be considered when applying the Five-Step Model to its contracts.
Facts
David and Susan Brown would like to send their only child, Rose, to Wonderful Private School (School). David and Susan complete an application and file it with School’s admissions office on April 1, 2019. They pay a nonrefundable application processing fee of $250 to School at this time. On April 15, David and Susan learn that Rose is accepted. On May 1, David and Susan enter into a signed written contract with School for Rose’s upcoming 7th grade year (the August 2019 to May 2020 academic period within School’s July 1, 2019 – June 30, 2020 fiscal year). The annual tuition is $10,500 – which includes an initial payment requirement of $500 due to the School on May 1. David and Susan elect to pay the remaining annual tuition of $10,000 in ten equal monthly installments, with the first payment of $1,000 due June 1. The contract clearly spells out each party’s rights and obligations, and the contract cannot be canceled by either party without incurring a penalty. David and Susan are well-respected members of the community who are known to generously support various local charitable organizations, and School is confident David and Susan will pay the monthly tuition according to the agreed-upon terms in the contract.
Step 1: Identify the contract with a customer
A contract between the Browns and School exists, as there is an agreement between the parties that creates enforceable rights and obligations.
Step 2: Identify the Performance Obligations in the Contract
The only performance obligation in the contract is for School to provide educational services to Rose according to the terms of the contract. (Note that the nonrefundable $250 application processing fee paid by the Browns at the time of the application was for processing the application and School has no continuing service obligation with respect to that payment.)
Step 3: Determine the Transaction Price
The transaction price stated in the contract is the annual tuition of $10,500.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
As noted in Step 2, there is only one performance obligation. Accordingly, the entire $10,500 contract amount is allocated to School’s one performance obligation, which is the responsibility to provide educational services to Rose.
Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation
School must determine whether it satisfies its obligation to provide educational services to Rose over time or at a specific point in time. The academic period runs from August 2019 to May 2020, and School will provide educational services to Rose ratably over the ten month period. Accordingly, tuition revenue of $10,500 will be recognized ratably over that period of time. The $500 nonrefundable tuition deposit and the first monthly tuition payment of $1,000 is classified as deferred revenue (a liability) as of School’s fiscal year end of June 30, 2019. The nonrefundable application fee is recognized as revenue by School in the period in which Rose’s application was processed, since School is under no further obligation to the Browns after it processed the application.
Note: The ASU allows, as a practical expedient, School to apply the guidance to a portfolio of contracts (or performance obligations) with similar characteristics if School reasonably expects that the effects on the financial statements of applying the guidance to the portfolio would not differ materially from applying the guidance to the individual contracts (or performance obligations) within the portfolio. As a result, School would likely account for all of its similar student tuition contracts in the same manner.
If School offers discounts to families (such as for multiple children or financial aid), such discounts should be accounted for as a reduction of the transaction price and, therefore, of revenue. If School offers a tuition benefit to employees, such reductions are given in exchange for distinct services provided to School and are reported as expenses (revenue is reported at the standard transaction price). The treatment of these items has not changed from previous guidance.
Interestingly, the accounting treatment prescribed by the ASU in this example for School is likely the same as that which would have occurred following the principles and practices commonly applied prior to the effective date of the ASU. Most educational institutions have historically applied the practice of recognizing tuition revenue ratably over the applicable academic period in which the educational services are provided to students. As a result, even though it applies new principles in arriving at the conclusion, the new ASU will have little or no impact on the timing of revenue recognition for many educational institutions.
Disclosure Requirements
The ASU also contains new disclosure requirements that are intended to help readers of financial statements better understand the nature, amount, timing, and uncertainty of revenue that is recognized – including information about receivables, performance obligations, and significant judgments made when applying the ASU to contracts.
Transition Guidance
If comparative financial statements are presented, an organization has two options:
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- All prior periods presented can be restated following the new guidance, or
- The new guidance can be only applied to the current year with no restatement of prior years.
Either option will require certain disclosures.
Implementation – Next Steps
If you believe the new guidance will significantly impact the revenue recognition model for your organization, you should:
- Become more familiar with the ASU’s Five-Step Model through additional reading and other learning;
- Identify the organization’s significant revenue streams;
- Read any contracts that you believe will be subject to the new guidance;
- Apply the Five-Step Model outlined above to each contract;
- Collaborate with others in the organization about the potential impact of the new guidance;
- Talk with your auditor to ensure your organization and your auditor have the same expectations regarding the impact of the ASU on your organization’s financial reporting; and
- Educate appropriate groups in the organization about the impact of the new guidance (if significant), including the board of directors and/or audit and finance committees.
A Final Word
The new ASU described in this article is not likely to have a significant impact on revenue recognition and financial reporting for most nonprofit organizations. And as is the case with all GAAP requirements, it is important to remember that the provisions of the new ASU need not be applied to immaterial items. For those organizations whose financial reporting will be affected by the new rules, the time to assess and implement has come.