By Jennifer L. DeBor, CPA, Audit Manager, McClintock & Associates, P.C.
If I had one word to sum up the Financial Accounting Standards Board’s (FASB) new revenue recognition accounting standard, it would be judgment. That’s what it requires, a well thought out assessment using various areas of judgment that supports your institution’s earning of revenue (feel free to count the number of times the word judgment is used within this article).
FASB jointly issued with the International Accounting Standards Board (IASB), Accounting Standard Topic 606 (ASU2014-09), “Revenue from Contracts with Customers.” This happens to be one of the projects undertaken by both Boards that they were able to successfully “converge” on accounting ideologies. This could be because, from a FASB perspective, this is a historical shift from a rules-based concept to a principles-based concept. For those non-accountants, this means that there is less bright-line guidance on how to apply the accounting standard, which causes more ambiguity, hence more professional judgment is required. The standard supersedes most industry-specific guidance.
The revenue standard is effective for fiscal years beginning after Dec. 15, 2017, for public entities and non-public get an additional year of reprieve. However, if a non-public institution issues comparative financial statements, they would need to assess the standard for the prior year.
The crux of the standard is that the recognition of revenue should represent the amount an entity (institution) is expected to receive for the transfer of its promised goods or services (education) to the customer (student).
The standard requires an institution to apply a five-step process to an entity’s contracts with its customers.
Step 1: Identify the contract with the customer
Step 2: Identify the performance obligations
Step 3: Determine the transaction price
Step 4: Allocate the transaction price
Step 5: Recognize revenue
In addition, to the five-step process of revenue recognition, the ASU also provides generally accepted accounting principles on the financial reporting disclosures.
You may be asking, what does this mean for your institution? The effect is that the current revenue recognition process related to tuition, fees, books, housing, etc. may change based upon the ASU which will have an impact on financial results. Let’s walk through the five steps below in more detail to begin to think about the various considerations for an institution. When reading below, keep in mind that within each step, there are various criteria that should be contemplated. The key considerations as it applies to the post-secondary education market will be discussed below. The specific nuances of each institution must be reviewed individually. As a caveat, the guidance in this article mainly relates to non-public institutions.
Step 1: Identify the contract with the customer
For this step, an institution needs to determine if a contract exists with its student. This step requires the institution to assess various aspects of a contract, such as approval by both parties, identification of rights and terms, and if it is probable, the institution will collect payments on amounts owed. Typically, institutions have written enrollment agreements, so the contract is easily identifiable. Within the enrollment agreement, both parties agree to the pricing, payment, and terms of the education with the ultimate completion of an education to earn a certificate, diploma or degree.
Part of this step includes the assessment of collectability on the contract, which is different than the current accounts receivable allowance and write-off policy institutions have implemented. Under the new standard, each contract would be assessed for its collectability unless an entity would elect a “portfolio” approach to assess collectability for the entire population. This portfolio approach would probably be available to institutions since the terms and conditions of the contract with students will be similar. The student population is homogenous, and collection of the portfolio is probable. That being said, an allowance methodology may still be applicable for students who have withdrawn from the institution.
Our initial assessment is that institutions have easily identifiable contracts with customers and a “portfolio” of students is mostly collectible especially considering that federal and state financial aid frequently cover a significant portion of the revenue.
Step 2: Identify the performance obligations
For this step, an institution must identify the promised goods or services its providing to a student. The institution must determine what goods or services are within the contract and if they are distinct, meaning the student can benefit from that good or service on its own. Those not deemed to be distinct should be combined as one promise, or commonly referred to as, one performance obligation.
When thinking about an institution, what sort of performance obligations exist within an enrollment agreement? The primary performance obligation of an institution is to provide a student with an education. An enrollment agreement details the various charges of education, including the tuition (the largest portion), books, lab fees, clinic revenue, application fees, dormitory fees, to name a few. What about performance obligations that may exist that don’t have specifically identifiable charges, such as job placement services or resume assistance?
An institution must assess, using judgment, as to what distinct services are being offered to students and whether specific charges exist or not.
You need to ask questions about the services being provided from the student’s perspective such as, can the student benefit from books outside of tuition? Can they be given a diploma or degree without taking the labs required? What about a non-refundable upfront fee? Is there any benefit being transferred to the student for that fee? These are all questions an institution must evaluate and answer to support their identification of the performance obligations.
For example, tuition, books, labs, job placement services, and resume assistance may be considered to be one promise, the promise of an education for the student, and are not considered to be distinct performance obligation and thus are bundled together as one performance obligation per the new ASU. Clinic revenue provides a separate performance obligation to customers since they are receiving a benefit of a particular service, such as a cosmetology service. Dormitory fees provide a place to live for a student and could be considered a separate and distinct performance obligation as it would not be a pivotal part of a student’s education.
Our initial assessment is that many student fees (lab fees, student service fees, etc.) would be combined with tuition as one performance obligation as these fees are not distinct services. Non-refundable upfront fees, like application fees, are interesting because while they are non-refundable, they do not satisfy a promise to the student, and would be combined with tuition.
Books sales made from a bookstore or which are separate charges would continue to be recognized as a point-of-service sale assuming the student has the right to keep the books. If books are included as part of tuition, an institution will need to evaluate as to whether the books need to be identified and recognized as revenue separately as a separate performance obligation. This conclusion may differ among institutions based upon the nature of the educational programs.
Institutions should begin to review all of their charges to determine if they are separate performance obligations or if they are merely an extension of the educational services being provided and thus earned commensurably with tuition.
Step 3: Determine the transaction price
After determining if a contract exists and identifying the various performance obligations, the institution must then determine the transaction price for the contract. The transaction price is the amount the institution is expecting to receive for its transfer of goods or services. In the transaction price assessment, an institution must consider the price being charged and also consider if there is any variable consideration, such as discounts or credits. Also, an institution should assess whether any non-cash consideration exists. The variables reducing the ultimate dollar amounts expected to be received, are to be accounted for as a reduction of the transaction price.
Institutional scholarships and refunds would be considered variable consideration and will be a reduction of the transaction price. Institutional scholarship amounts which are known when the tuition is charged should be a reduction to the tuition charge. Therefore, institutional scholarships will be recognized as a reduction in tuition and not as an expense. Tuition adjustments for terminated or withdrawn students may require an estimated accrual at the time tuition is charged, which would be a reduction of revenue and creation of a corresponding liability.
Creating an estimate for terminated or withdrawn students may be a new practice for an institution and the portfolio approach can be used for this estimate, as well.
For schools whose terms don’t cross over their financial reporting periods, the impact of tuition adjustments and institutional scholarships will be minimal as these items will be fully recognized. The impact of tuition adjustments and institutional scholarships will be more applicable for institutions whose terms or programs cross over the financial reporting period. However, for these institutions, an estimate can be made for future tuition adjustments to properly reflect institutional scholarships for active students as of each financial reporting period.
The standard also includes a provision for financing components that an institution would need to evaluate for institutional loans. This is beyond the scope of this article, but our initial assessment is that for many institutions this impact would not be material.
Step 4: Allocate the transaction price
The next step is allocating the transaction price, determined in step three, to the various performance obligations if more than one exist. Transaction prices for distinct obligations should be based on their standalone selling price, and if not observable, it should be estimated.
This area of judgment should not be too difficult in assessing for an institution. The amounts charged to students are typically shown explicitly within the enrollment agreement or the institution’s published catalog. For example, if the institution’s promise is determined to be mainly of one performance obligation, that of education, the institution would aggregate the amounts charged for the application fee, tuition, potentially books, and labs and earn that total amount over the method identified in Step Five. As most of the fees for institutions are defined, the estimation process would be minimal. The main estimates for an institution will be reductions in revenue for the portfolio of active students related to tuition adjustments as mentioned above in Step Three.
Dormitory fees may be considered a separate performance obligation, and an institution would then allocate the dormitory fees to that performance obligation based on the price in the housing agreement. Clinic revenue would continue to be earned based on the particular service performed and the retail price as a point of service sale (no change from current practice).
Step 5: Recognize revenue
The final step is to recognize revenue as the institution satisfies a performance obligation. For an institution, revenue should be recognized as the benefit is transferred to the student and determine if that benefit is at a point of time or over time. When determining this, the guidance provides indicators of transfer, some being the right for payment, legal title, and the ability to direct the use or benefit from the good or service.
Clinic revenue is a fairly easy assessment as that performance obligation is satisfied at a point in time, or when the service is performed. No further consideration would be necessary.
When it comes to the performance obligation of an education for the student, an institution may ask, would the education be transferred over time or upon completion of the diploma or degree?
The key to this assessment is determining when the student actually starts to receive benefits. The argument would be that as the student progresses throughout their courses, they are learning and increasing their knowledge of a subject matter. In addition, the institution has a right to payment as the student is in school and attending classes and therefore earned over time. This concept is also consistent with regulatory federal and state refund policies.
When assessing those obligations earned over time, an additional assessment of how to earn revenue is necessary. FASB guidance provides generic terms for earning revenue over time. They emphasize earning in a pattern that reflects the transfer of the benefit. Within the guidance, they provide for output methods; measured based on value to the student, program milestones, credits earned, or classes completed, or input methods; measured based on professor hours or time elapsed. This is where an institution would need to use judgment on how to earn over time. A clock hour program may be considered an input method, and revenue would be earned based on hours. This may not be different from what is done today as it corresponds directly with the benefit being transferred to the student. A term based program may be considered an input method based on time elapsed, and again may not be much different from how it is earned today under the existing guidance. As a result, our interpretation is that the revenue recognition methodology for an educational services performance obligation would be similar to the current methodology utilized by institutions for tuition and possibly fees. The main change will be including ancillary fees and charges which may need to be earned as part of the tuition performance obligation and not earned immediately as under current practice.
For dormitory charges, an institution would earn these fees over time consistent with current practice.
One more consideration for institutions related to recognition of revenue would be the impact of externships. The student would still be obtaining benefits during this period even if they were charged tuition for this earlier in the year. An institution would need to assess how revenue is recognized currently versus what may need to change as the student is earning a benefit during that externship.
From a pure reporting perspective, the face of financial statements themselves won’t change significantly. The concept of unearned revenue and deferred tuition still exists. What is different is that the standard requires a “netting” presentation, meaning the accounts receivable are interdependent with the deferred tuition and should be netted down. For some institutions, this may require an additional step of analysis or level of detail than what they currently use. Please note that in the netting process, credit balances, or refunds due back to the student, should not be netted with accounts receivable and also not included within deferred tuition.
Unfortunately, in terms of changes, the same can’t be said for the disclosure side of reporting. The standard requires a significant amount of qualitative and quantitative financial statement disclosures. The goal of the increased amount of information is to allow the users of the financials to understand the institution’s earning of revenue and the judgments used in its assessment. The standard is driving home the need for increased transparency and comparability among institutions. Such things as a breakdown of an institution’s revenue by geographic locations, diploma or degree programs is required. An institution will also be required to provide, in detail, its judgments used and how it is earning the various streams of revenue. For some institutions, this may require additional time to pull the data together and prepare the wording of the disclosures.
You may now be asking what does this mean for me and my institution and what should I do next? An institution should consider the following as it begins to implement the new revenue standard.
- Take stock of all its current revenue related to contracts with its students or other parties.
- Determine how revenue is currently being earned by performance obligation and compare that to how it should be earned under the new standard following the five-step process.
- Assess the institution’s revenue and student information systems to determine if any coding changes are needed to allow for revenue to be earned appropriately.
- Determine what impact the change in revenue recognition may have on the timing of the earning of revenue which could impact an organization’s composite score ratios, debt covenant ratios, or bonus plans.
- Plan for employee training related to any changes and allow for more time in the compilation of revenue related data and the financial statement disclosures.
- Document the revenue recognition process in detail through a formal policy.
At the end of the day, will the earnings process change significantly for your institution? The standard should not affect cash flow or the timing of Title IV funding. The changes surround the potential timing of revenue recognition, presentation and disclosures within the financial statements, and any operational changes due to the implementation of the new ASU. What will be key for the institution is to follow the five-step process when assessing its revenue related contracts and to document conclusions.
Where there is more judgment, the greater the need for a well-documented process to support your institution’s stance on the earnings process.
So, how many times was the term judgment used? True to form from a certified public accountant, 12 to be exact. While judgment is required under the new ASU, we don’t believe the impact will have a material financial impact on institutions. The biggest change will be evaluating the nuances of the various performance obligations, collectability of the student “portfolio,” and the estimation of future tuition adjustments. We are continuing to monitor published implementation guidance for the ASU and will be discussing the impact among our clients. If you have any questions, we are available to discuss them with you.
JENNIFER DEBOR PH.D. is a Certified Public Accountant who has over ten years of professional experience and is an Audit Manager at McClintock & Associates, P.C. Jennifer provides clients with a full range of audit and business consulting services, including financial statement audits, reviews, and compilations, transaction services for buyers/sellers, 90/10 calculation reviews, composite score projections and planning, and financial statement reporting consulting and understanding of new accounting requirements. Jennifer began her career with PricewaterhouseCoopers where she worked on a variety of clients in both the public and private sector, as well as financial services and manufacturing industries. Prior to joining McClintock & Associates, Jennifer worked as a Finance Director at a large healthcare organization. In addition to her professional responsibilities, Jennifer is a Board Member of Face2Face Healing a non-profit organization based in Pittsburgh, Pennsylvania.
Contact Information: Jennifer L. DeBor, CPA // Audit Manager // McClintock & Associates, P.C. // email@example.com // 412-257-5980 // https://www.mcclintockcpa.com/ // Social Media: https://www.linkedin.com/in/jennifer-debor-cpa-a4b92a3/