Accounting Standards Codification Topic (ASC) 606, Revenue from Contracts with Customers offers significant change with respect to how enterprises, including not-for-profit organizations, recognize revenue. This new standard replaces most historic revenue recognition guidance including some industry specific guidance.
ASC 606 establishes a five-step method for revenue recognition that applies to most contracts with customers. In addition to changing the way revenue is recorded, this standard calls for an update to financial reporting policies and disclosures. Organizations will need to show that they considered the standard, and have developed and documented their customary business practices for providing services.
There are some key facts and circumstances that organizations will need to evaluate. An organization should start by identifying its contracts, then identify its performance obligation, and determine whether the consideration received should be included in the transaction price. Ultimately, the organizations will recognize revenue when (or as) it satisfies the performance obligation.
The first step is identifying whether you have a contract with a customer. The standard defines a contract as an agreement with another party that creates enforceable rights and obligations. Once it has been determined that a contract exists, step two will be to identify the performance obligation – the promise to transfer goods or services to a customer. Step three entails determining the transaction price. The transaction price will reflect the organization’s expectation about the consideration it will be entitled to receive for providing the goods or service. Under ASC 606, the organization will only recognize revenue in the amount that it expects to receive.
Moving onto step four, the organization will allocate the transaction price to the performance obligation of the contract. This includes determining if those goods or services provide a distinct service, or a bundled service. Typically, each individual contract would need to be evaluated; however, this is not always practical and so a practical expedient is available – the portfolio approach. The portfolio approach allows contracts with similar characters to be grouped together for analysis. This will define the measurement timing for revenue. The final step, will be to recognize revenue when (or as) the organization satisfies the performance obligation by transferring a promised good or service to a customer. The amount of revenue recognized is the amount allocated to the satisfied performance obligation. Performance obligations may be satisfied over time or at a single point in time. For those satisfied over time, an organization recognizes revenue over time by selecting an appropriate method for measuring the organization’s progress toward satisfaction of that performance obligation.
The standard requires an organization to provide disclosures relating to: revenue recognized, contract balances, performance obligations, and significant judgments and changes in judgments. Additional disclosure is required to provide quantitative or qualitative information about the assets recognized from the costs to fulfill a contract.
While most of these changes may not have a significant impact for most not-for-profit organizations, this is not true for Continuing Care Retirement Communities (CCRCs). The effect is significant and may require CCRCs to restate their financial statements for revenue previously recognized as well as record liabilities for certain refundable entrance fees.
The CCRC Case Study
Agreements between CCRCs and residents meet the criteria for a contract under the standard. These resident agreements are typically all-inclusive, including residential facilities and access to health care services. The entrance fee in these types of arrangements is usually fixed at the time a resident agreement is signed. The resident agreement may contain two types of payments – the entrance fee and monthly fees. Fees may be refundable, nonrefundable or a combination of the two. Refundable entrance fees are those that are guaranteed to be refunded regardless of when the resident agreement is terminated. Nonrefundable entrance fees are either nonrefundable at inception or have a decreasing basis to the point they become nonrefundable.
If a resident pays a fixed monthly fee with inflationary increases for the use of the facilities and access to its health care services this is an example of a monthly resident agreement with the option to renew. These monthly fees would be included in the transaction price as the option to renew is exercised.
Nonrefundable vs. Refundable Advance Fees
The resident agreement identified above provides that a resident will be able to live in the CCRC and have access to whatever care they might need with little to no increase. These services are dependent on the individual’s needs and the length of time they continue to reside within the CCRC. In this situation, a nonrefundable fee contains the material right for future goods and services. In this example, the nonrefundable fee is a component of the transaction price.
Refundable entrance (advance) fees are expected to be refunded even if the resident agreement is terminated. Based on this, consideration received from a customer should be recognized as a liability if the entity expects to refund some or all of that consideration to the customer. The measurement is based on how much the organization expects to refund at the termination of the resident agreement. CCRCs are contractually obligated to refund the refundable entrance fees and as such, these fees should be recorded as a liability at the inception of the resident agreement. The refundable fee should not be included in the transaction price, because the CCRC expects to refund these amounts when the resident agreement is terminated. The Financial Reporting Executive Committee (FinREC) a committee of the American Institute of Certified Public Accountants (AICPA) that determines the AICPA’s technical policies regarding financial reporting, believes that these fees are not part of the transaction price and therefore would not be considered in the recognition of revenue.
Monthly fee revenue would be recognized when the services for the month are performed. The monthly fees entitle the residents to the use of the residential facilities and other amenities, as well as access to health care services. The CCRC providing these monthly services satisfies its obligation to the resident of the CCRC.
A nonrefundable entrance (advance) fee requires a bit more judgment as it provides a material right to access future services. Because nonrefundable entrance fees contain a significant financing component, judgment will be required to determine how to account for the revenue. Acceptable methods could be time based, cost to cost or another reasonable allocation method. Most CCRCs allocate the revenue based on the estimated future life expectancy of the resident, which is generally considered a reasonable method of allocation.
As noted, ASC 606 applies to all organizations, not just CCRCs and implementation considerations should be well under way at this point. For public business entities and certain not-for-profit entities and employee benefit plans filing with the SEC, the effective date is for annual reporting periods beginning after December 15, 2017. The effective date for all other entities is annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019.
Janine Mangione is a partner based out of our Albany, NY office.