First Steps to Tackling the New Model for Revenue Recognition by Christopher Cichoski, CPA
Businesses large and small and across virtually all industries face a perfect storm of financial reporting compliance challenges to contend with in the coming months. On the near horizon are the new revenue recognition standards, which go into effect for public companies, employee benefit plans and certain not-for-profit entities beginning after Dec. 15, 2017, and Dec. 15, 2018, for private companies. The new method for recognizing revenue from contracts with customers can be a heavy compliance burden on affected businesses. Among the challenges business will face are significant investments of time, resources and coordination across multiple business functions to review how the new standard will affect their financial reporting in the future and potential requirements to change existing contracts, business policies, practices and technology – all while maintaining normal business operations.
Rather than watching the clock count down and awaiting industry-specific implementation guidance from the American Institute of CPAs (AICPA), businesses should be taking the following steps now to make the eventual transition as smooth and seamless as possible.
Understand the Basics of the New Model of Revenue Recognition
In 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) introduced ASU 2014-09 to simplify how businesses in different industries book revenue for similar transactions and ensure that they present their financial results in a manner that is comparable across all industries and capital markets. The new model does away with disparate industry- and transaction-specific financial reporting requirements in favor of a more principles-based approach that businesses in all industries and countries will use in the same consistent manner to report the “nature, amount, timing, and uncertainty of revenue and cash flows arising from a contract with a customer” in the same consistent manner. More specifically, the model requires businesses to take the following five steps:
- Identify each customer contract
- Identify each and every “distinct performance obligation”, or separately identifiable goods and services, they promise to deliver
- Determine the transaction price(s) they “expect to be entitled to” under the terms of the contract
- Allocate the transaction price to each separate and distinct performance obligation
- Recognize revenue when the entity satisfies each separate performance obligation
Ultimately, businesses will need to identify each distinct product and/or service they provide and determine when and for how much they can recognize the proportionate revenue from each individual obligation contained in each separate customer contract. Despite the universal application of the five-step model, businesses will be impacted differently from one company to the next and from one industry to another.
Develop a Team to Spearhead the Process
Do not make the mistake of assuming that the new standard of revenue recognition is merely an accounting or finance issue. Rather, businesses of all sizes should recognize the impact the new rules and how they must recognize revenue in the future will have on all of the people, processes and systems throughout their organizations, including sales, IT, legal, accounting and financial reporting.
Remember, this is a marathon, not a sprint, and it will require significant amounts of time and teamwork to gather and analyze information, assess the impact of the new regulations on their current operations and make needed adjustments. For example, compliance with the new standard may require businesses to change their pricing structures and sales incentives, as well as employee compensation and the IT systems that manage and control these functions.
Assess Contracts with Customers
Gathering and analyzing information related to all of a business’s existing contracts is pivotal to implementing the new regulations. For one, businesses may find that existing contracts based on currently acceptable “persuasive evidence of an arrangement” will not qualify as contracts with customers under the new regime of revenue recognition, which requires that all of the following conditions be met:
· The agreement specifies the legally enforceable rights and responsibilities of both the buyer and the seller, including the payment terms for the transfer of goods and/or services
· Both seller and buyer approve the contract (in writing or orally) and agree to perform their respective contractual obligations
· The agreement has commercial substance, for which both buyer and seller can expect their respective cash flow to change as a result of the transaction
Identify Distinct Promises for Goods and Services
Under the new standard, businesses must determine, within the context of customer contracts, each separate and distinct good or service they promise to transfer to the customer as well as the timing and amount of revenue they may recognize from each individual obligation contained in the contract. More specifically, the regulations define “distinct” goods and services as those in which
1. the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer or
2. The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract
In other words, businesses must determine whether they promise to transfer each good or service individually or as combined goods and services. For example, a business may integrate and bundle together multiple promises for goods or services (inputs) to deliver to the customer one combined output. Similarly, multiple goods or services may be interdependent or interrelated with each other, such is the case with software and subsequent updates, for which two or more goods or services may be combined into one promise to transfer goods and services. In some situations, a business may find that contract components that they previously bundled together should be identified separately under the new regulations.
Yet, there are times when a contract with a customer may include “implied” promises to transfer goods or services that are not explicitly identified in a contract as separate performance obligations. Rather one or more phases, elements or units of a performance obligation may be bundled together into one combined output(s). For example, if a business performs shipping and handling services to fulfill its obligation to transfer ownership of a product to a customer, those activities will not be considered separate performance obligations that would otherwise require additional contracts. Therefore, the seller may recognize revenue from the sale of a product at the time that it ships the good to the customer. Conversely, if a seller, under its normal business practices, has a history of reimbursing customers for goods that have been lost or damaged in transit, it may consider this coverage of risk to be a separate services for which revenue may be recognized only after the customer physically receives and accepts the product.
Generally, the following factors will indicate that two or more promises to transfer goods or services to a customer are not separately identifiable:
1. The entity provides a significant service of integrating the good goods or services with other goods or services promised in the contract.
2. One or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised in the contract.
3. Each of the goods or services are highly interdependent or highly interrelated in ensuring the seller can fulfill its promise to transfer each of the goods or services independently.
Know When to Recognize Revenue
In order for a business to recognize revenue from performing a particular performance obligation, the following criteria must be met:
· The seller transfers title and delivers the product or services to the customer, who accepts the goods and services along with the risks and rewards of ownership
· It is probable that the seller will receive payment for the transaction
· The “amount of revenue can be measured reliably”
· The seller substantially completes or fulfills the terms specified in the arrangement with only inconsequential obligations remaining.
Businesses will need to consider a myriad of issues that can affect these requirement, including, but not limited to, the definition of title transfer, customer acceptance and substantial completion of contract terms; the effect of undeliverable products, customers’ rights of return and refunds on their recognition of revenue; and sales involving “multiple element arrangements” for which the new method for recognizing revenue may need to be applied to each distinct obligation separately.
Consider Non-Revenue Impact
Depending upon the industries in which businesses operate, the new standard for recognizing revenue from customer contracts could have significant impact on their non-revenue financial reporting.
For example, product-service warranties that businesses offer customers will need to be treated under the new regulations as separate performance obligations for which revenue allocation will change from current practices. In addition, businesses may be required under the new standard to capitalize and defer recognition of certain costs that they currently expense and record in the current year. This may allow businesses to depreciate or amortize over time the costs they incur for direct labor and materials, bids, sales commissions and subcontractors.
Similarly, the new standard will change the way in which businesses treat sales of non-financial assets, such as real estate, property, plant and equipment, outside of their normal and customary business activities. The timing and measurement of the gains and losses from these sales, which businesses will recognize separately on their financial statements, may be different from current practices.
When considering the impact that the new regulations will have on the recognition of revenue it is reasonable to assume that it will also affect the timing and amount of taxable income the business will report. As a result, businesses should begin thinking now about potential revisions they will need to make to pricing arrangements and all internal controls related to income tax accounting.
This assessment of customer contracts and different performance obligations can be a daunting challenge, especially for small to mid-size businesses that do not have in place the appropriate systems required to analyze and dissect this information. The same is true for bigger businesses with very large numbers of customer contracts and sources of revenue, some of which may be combinations of bundled products and services, including discounts, licensing fees, interest and dividends, royalties and rent.
The advisors and accountants with Berkowitz Pollack Brant work with businesses across all industries to develop and implement strategies that meet ever-changing financial reporting and disclosure requirements.
About the Author: Christopher Cichoski, CPA, is a senior manager in the Audit and Attest Services practice with Berkowitz Pollack Brant, where works closely with business clients in the real estate and construction industries as well as with non-profit organizations. He can be reached at the Miami CPA firm’s office at (305) 379-7000 or via email at firstname.lastname@example.org.