Revenue Recognition Standard: Not Your Typical Accounting Change
Julie Killian
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.
Possible Impacts
- Timing of revenue recognition
- Revenue-based metrics
- Contract negotiations with customers
- Debt covenants
- Employee bonus compensation (sales based compensation)
- Footnote disclosures in the financial statements
Check If Contracts Have Any of These Factors
- Multiple goods and/or services
- Span more than a year
- Change during the contract term
- Include variable consideration
- Costs to obtain or fulfill the contract
- Licenses or royalty arrangements
- Compensation or debt linked to revenue
It is important that businesses start looking at their contracts, purchase orders or other documentation of a “sales arrangement” as the literature includes implied contracts. These arrangements with customers should be looked at individually in the context of the new standard to assess how the new requirements will affect them.
Five-Step Plan
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
Revenue Recognition Standard
| Question | What’s Different | Action Item |
| Are there multiple goods or services combined in one contract (software and service, production and installation, tooling and production, etc.)? | New separation criteria and consideration of performance obligations may change which deliverables are combined into a single performance obligation, and which are separate.
The transaction price will be allocated according to stand-alone selling prices of each performance obligation. These criteria may cause revenue recognition to be earlier or later than it is today. Revenue may also be split between different deliverables. These changes may affect key performance indicators. |
Using the separation criteria in the standard, determine which deliverables in the contract are separate performance obligations, and which deliverables will get combined as a single performance obligation.
Decide how standalone selling prices for each performance obligation will be determined, and allocate the transaction price based on the ratio of standalone selling price to total price. |
| Does the client have contracts that span more than a year? | New criteria in the standard have to be applied to determine if revenue will be recognized as work is performed, or only when work is complete. No separate percentage of completion method is available. | Make sure internal processes are designed to capture the correct method and timing of revenue based on the contracts. |
| The standard may cause changes in the method of recognizing contract progress. Progress has to be measured in a way that best depicts performance. | Determine inputs or outputs of the long term contract that best reflect performance (milestones, surveys, costs, time, labor or machine hours, material used). | |
| Payments received in advance, or in arrears, may need to be accounted for separately as financing income or cost, changing the amount of sales revenue recognized. | For different payment arrangements make sure that there are systems in place to capture the time value of money adjustments and to determine the interest rates to be applied. | |
| Does the client sell licenses or do they earn revenue through royalty agreements? | Under the new guidance, revenue from licenses may be recognized up front or over the license period, depending on circumstances. | New judgments as to whether licenses are distinct.
Need to determine if licenses provide access to intellectual property, or a right to use. |
| Do client contracts include variable consideration? | Variable consideration is defined as discounts, refunds, rebates, credits, incentives, penalties and contingencies. How variable consideration is handled is specified in the standard.
It will be included in revenue only when it is “highly probable” that there will be no significant revenue reversal in the future. |
Identify if significant revenue reversal is possible.
Develop a process to determine consideration in a contract, including judgments about variable consideration. Develop a system to track and record variable consideration. |
| What costs does the client have to obtain or fulfill a contract? | If the cost would not be incurred if the sales contract was not obtained, then the cost to get the contract is capitalized and amortized over the life of the contract. In companies paying commissions based on sales, this will cause commissions to be capitalized and amortized. | Systems need to capture costs for capitalization and amortization. |
| Does the client have contracts that change throughout the term of the contract? | Changes to a contract are recognized only when the change is approved.
There are multiple ways to account for changes to contracts. |
Make new judgments when accounting for contract modifications depending on situation. |
| Does your client have compensation or debt linked to revenue? | Changes in revenue and cost recognition could mean incentive and compensation plans may no longer reflect corporate goals. | Amend incentive plans and communicate changes. |
| Changes in earnings may affect compliance with debt covenants. | Renegotiate debt agreements. |
Three-Phase Implementation
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 five 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
Clayton & McKervey has a team of professionals who can assist with the planning and implementation required to adopt the new standard. Contact us to learn how we can help.
Seven Key Facts about Revenue Recognition
- Its reach is broad
- You’ll need a shift in thinking
- Organizations will likely be making more disclosures
- There have been updates and modifications to the standard since it was first issued
- Be prepared to follow the five steps
- It would be a mistake to postpone tackling this one
- Your CPA has access to a wealth of implementation resources