The much-anticipated new standard for recognizing revenue goes into effect in 2019 for non-public companies. That time-frame may lull management into believing they have ample room to tackle the issue. However, feedback from early adopters suggests it takes far more time to absorb the organizational impact than one might think. Word to the wise: get started now!
Does this impact your company?
Many companies believe the new standard will not impact them because they do not have contracts with customers or because they recognize revenue at the point of sale. However, it is important to understand this standard will apply to all businesses that recognize revenue from customers. A contract by definition is an agreement between two or more parties that creates an enforceable right and obligation, whether verbal or written, and can be as simple as a standard purchase order.
Some believe implementation is not required because the ultimate recognition will be the same under the new standard. This is also misleading, as the standard will require full implementation efforts even if there is no change in the amount of revenue recognized. This will require walking transactions through the five-step model below and drafting the appropriate financial reporting disclosures.
ASC 606 is a Generally Accepted Accounting Principles (GAAP) change that effectively replaces the current revenue recognition standard across all industries and will affect all companies. The standard has changed, and it is the responsibility of your accountant to make sure that you have adopted and implemented the standard. The following steps can help frame your analysis and assist in an assessment of your compliance with the new standard.
Why did the standard change?
For years, GAAP supported different mechanisms for addressing contract sales across industries even though many of the underlying transactions were similar. Disparities also existed between U.S.-based and international corporations. The new revenue recognition standard reflects the combined efforts of the Financial Accounting and Standards Board (FASB) and International Accounting Standards Board (IASB) to establish greater uniformity across industries and nations.
The organizing principle of the new standard dictates that revenue recognition should depict the transfer of goods or services to customers in an amount that reflects the consideration to which they expect to be entitled. Variable consideration – e.g., discounts, rebates, refunds, warranty coverage, customer reward programs – leave open the possibility of payment below the negotiated price and therefore an estimated portion of that revenue stream must be deferred.
What process supports adoption of the new standard?
The FASB prescribes a five-step model through which companies evaluate their contract revenue and respond to the precepts of the new standard.
1. Identify the existence of a contract with the customer.
Contracts can range from a complex document that has been carefully crafted, negotiated and executed to a simple purchase order. As such, contract review must include transactions that may not look like a formal contract on the surface.
As defined within the new standard, a contract is an agreement between two or more parties that creates enforceable rights and obligations. Contracts can be written, oral, or implied by a company’s customary business practices.
2. Identify the separate performance obligations of the contract.
The standard defines a performance obligation as a promise in a contract with a customer to transfer a good or service to that customer. At contract inception, a company should assess the goods or services promised in a contract with a customer and should identify as a performance obligation, or multiple performance obligations, each promise to transfer either a distinct good or service, or a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
Product sales could include resale rights, licenses, options related to future purchases (e.g., discounts, guaranteed availability), and construction, manufacturing, or developing an asset on behalf of a customer. Services could include discrete tasks, a standing service arrangement (e.g., tech support, software upgrades), and arranging for other parties to provide goods and services. When two or more goods and services collectively fulfill a commitment, the accounting treatment must consider them an integrated whole.
3. Determine the transaction price.
The standard states the transaction price as the amount of consideration to which a company expects to be entitled in exchange for the transfer of goods or services to a customer. The transaction price includes variable consideration, significant financing, non-cash consideration, and consideration payable to the customer. As the components of the transaction price may relate to an unknown future (e.g., return rates), management must use their judgment based on facts, historical trends and logic. Decisions must be documented for review during the annual audit and updated periodically to reflect changes in the company’s experience.
4. Allocate the transaction price to the performance obligations.
The standard states that for a contract with more than one performance obligation, the company must allocate the transaction price to each distinct performance obligation on the basis of their stand-alone selling price. The company must use an observable price or estimate using an approach that maximizes observable inputs.
5. Recognize revenue when performance obligations are satisfied.
A performance obligation is satisfied when the customer obtains control of the good or service. Factors influencing this treatment include mutually agreed-upon measures of progress, transfer of control, enforceable rights to payment and lapses in time periods over which customers may lodge complaints or seek remuneration.
Does this change affect other areas of the company?
While the standard may seem to be confined to the accounting department, several interested parties need to be included in the conversation as you adopt the new standard. In particular:
The current accounting system may not provide sufficient flexibility to accommodate the new reporting requirements
Accountants will need to adjust the company’s book-to-tax calculations and deferred tax liabilities based on anticipated changes to the annual filings.
Chief Financial Officer
Adjustments to the financial statements may affect lending covenants and should be brought to the attention of the CFO as soon as possible.
The company may need to educate current and prospective investors on this adjustment should the change evoke concern about the company’s growth trajectory or overall health.
Standard practices may be altered should it provide a more attractive stance regarding revenue recognition or lessen accounting’s administrative load.
Anyone earning performance-related pay
Sales commissions and incentive-based management bonus pay frequently tie to revenue. These plans may need to be adjusted.
A final message from early adopters suggests the disclosure burden in the annual report was larger than anticipated. It’s a risk factor that could delay publication of the audited financial statements. As such, we recommend you draft your disclosures early so you’ll know what numbers you need to collect.
What should I do now?
Your accountant can work with you to kick-start your efforts using templates that align with the five-step model as well as providing guidance for your specific industry. You can expect the review, procedural modifications and documentation to consume a healthy amount of time, so consider assigning a specific employee or team to the task and hold them accountable. Document your process of contract review and consult your accountant early and often. You also need to consider if you will adjust your 2018 financials retrospectively or adopt a modified retrospective approach, which allocates all prior period adjustments to January 1, 2019, retained earnings.
This process will require a systematic approach and it cannot be effectively performed at the last minute, so discuss with your team and professionals at the earliest opportunity.
Meet the Author
Kellan Davis, CPA
Aldrich CPAs + Advisors LLP
Kellan has over five years of experience with national and regional public accounting firms working in a variety of industries including manufacturing, construction, software, lending, retail, telecommunications, nonprofit and benefits plans. He now actively serves his clients as a member of Aldrich Manufacturing and Distribution group and specializes in revenue recognition. Kellan is originally from…
- Revenue recognition
- Certified Public Accountant
- Lease accounting