Five-Step Revenue Recognition Implementation
The accounting industry identified the need to form a single, unified, global revenue recognition strategy 15 years ago; announcing the final standard in May 2014. While this announcement may have been years in the making, the time for companies to absorb and implement the changes is now.
In general terms, the new standard moves from the rules-based approach accountants are used to in US GAAP to a more principles-based approach, and eliminates the industry-specific guidance providing fairly straightforward methods of recognizing revenue in an entity. Instead, it offers very broad guidelines requiring significant judgment to recognize revenue across most industries. Rather than determining which US GAAP standard to apply to a transaction, management must now determine how to apply this single standard to all transactions. This new standard takes effect in 2018 for public company financial statements, and in 2019 for private entities.
The new standard offers two adoption methods from which to chose: the “retrospective method” or the “cumulative effect” method. Although it may seem as if there is plenty of time, the work involved in preparing for this change will be extensive. For most, this change will be the largest and most complex accounting project experienced in the profession.
Impacts of the Change
Different industries will see varying levels of impact from the new standard implementation. Some of the most significant indicators of change are as follows:
- Complex contracts with numerous variables or terms and conditions
- Contracts with multiple revenue streams, such as a contract providing tooling and production parts
- Contracts which are not well documented; resulting in data which will be difficult to accumulate
- Contracts with variable consideration
- Contracts containing significant costs in order to obtain the contract, such as sales commissions
- Contracts providing a customer with the right of return, or which have customer acceptance provisions
- Contracts with customer warranties
Tackling the standard is a daunting task. The initial Accounting Standards Update 2014-09 included 156 pages and many subsequent clarifications. Although there are numerous considerations for each contract, the starting point at the most fundamental level is clear. The standard has five distinct steps that have to be performed in order to recognize revenue:
- Identify each contract the company has with a customer
- Identify the performance obligations in the contract
- Determine the transaction price for the contract
- Allocate the transaction price to each specific performance obligation
- Recognize the revenue when the entity satisfies each performance obligation
Each customer contract must be evaluated separately in the context of the new standard and the five steps, without regard to how revenue was recognized for that contract in the past. Each of the five steps has many potential judgments and variables to be considered, which translates to the need to make a commitment of time and resources to adopt the new standard.
If your company has not already developed an implementation plan it is highly recommended that you commit to a plan early this year. For private companies a good timeline would be as follows:
Overview of Each Phase
1. Contract & System Analysis
- Assign a team to understand the standard and to lead the implementation, if this has not already been done
- Educate team members and others internally
- Make a tracking spreadsheet of all contracts and terms
- Identify the current processes for initiating, storing and accounting for contract data
- Determine if you will use a retrospective or cumulative effect transition method
- Utilize the new standard by applying the 5 steps to individual contracts
- Determine the differences from current GAAP, and review the impacts
- Document judgments made for each contract
- Consider the need to change any processes including IT systems and internal controls
2. Beginning Implementation
- Consider running parallel revenue recognition systems
- Determine the full financial impact the standard will have taking into consideration things such as key performance indicators, debt covenants, and compensation agreements.
- Communicate with key stakeholders, such as bankers, investors, governing boards and any others who may be impacted by the change in revenue recognition.
3. Mandatory Implementation
- Implement the transition method selected to the contracts
- Implement any changes needed to IT systems, processes and controls
- Continue to keep an open line of communication with key stakeholders during implementation
As a firm, we invested in hiring an expert from the AICPA to run a workshop and help us understand the nuances in the literature. Clayton & McKervey has a team of professionals who can assist with the planning and implementation required to adopt the new standard.