A New Revenue Recognition Standard for Customer Contracts
After a dozen years of collaboration and controversy, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) finally have agreed on how and when companies should recognize revenue. Considered the “crown jewels” of accounting convergence efforts, Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, and International Financial Reporting Standards (IFRS) 15 are expected to produce a major shift in how companies report the top lines in their income statements. But many are unsure exactly how the changes will pan out.
Plus, click here to learn the five steps that companies will follow to decide how and when to recognize revenues.
A giant leap toward global consistency and transparency
The divergent approaches to revenue recognition epitomize the key difference between U.S. Generally Accepted Accounting Principles (GAAP) and IFRS. IFRS tends to be principles-based and require limited disclosures. Conversely, GAAP represents the prescriptive end of the financial reporting spectrum. When it comes to recognizing revenue, U.S. companies currently must follow FASB Codification Topic 605, Revenue Recognition, as well as 80 pieces of industry-specific revenue recognition rules.
Starting as early as January 2017, the new rules will become part of FASB Codification Topic 606, Revenue from Contracts with Customers, which will supersede the previous hodgepodge of revenue recognition requirements. Under the new rules, companies worldwide will follow a single set of principles for reporting revenue from customer contracts.
Longer contracts, bigger changes
For simple point-of-sale retail transactions, revenue is realized when goods or services are delivered to the customer. The process gets more complicated for long-duration, multi-element contracts, sales that include incentives for customers with poor credit, and contracts with built-in discounts or performance bonuses.
Under the new rules, companies must determine the expectation of collecting payments owed to them by recording revenue only to the extent that it’s “probable” they won’t have to make a significant reversal in the future. For the first time, they also must adjust the transaction price to reflect the time value of money.
The breadth of change that will be experienced depends on the industry. Companies that currently follow specific industry-based GAAP, such as software, real estate, asset management and wireless carrier companies, will feel the biggest changes. The new rules also provide guidance for transactions that weren’t addressed completely, such as service revenue and contract modifications.
Nearly all companies will be affected by the expanded disclosure requirements. The new rules call for detailed footnote disclosures that break down revenues by product lines, geographical markets, contract length, services and physical goods.
Exceptions to the new rules includeinsurance contracts, leases, financial instruments, guarantees and nonmonetary exchanges between entities in the same line of business to facilitate sales. These transactions remain within the scope of existing industry-specific GAAP.
The hard work continues
Many accountants, auditors and managers believe the hardest work is yet to come. The new standard is ushering in a sea change to the way companies calculate their revenues, which inevitably means there will be a learning curve.
For public companies, the new guidance is effective for annual reporting periods beginning after Dec. 15, 2016 (including interim reporting periods), and early implementation is not allowed. Private companies are given an extra year to implement the new rules — or they may choose to implement them at the same time as public companies.
Despite having more than two years before the new standard becomes effective, most companies should start gearing up for adoption now, especially if they choose to adjust their results from previous periods and follow what the standard-setters call a “retrospective” transition to the new accounting regime.
Regulatory filings will continue to be reported under the existing revenue guidance. But with retrospective application, companies will have to calculate their revenue under the new standard so they can provide the three-year comparison when the new standard becomes effective.
Companies also have the option to make a simpler transition, using the “cumulative catch-up method.” This would require businesses to use the new revenue guidance only for long-running contracts that exist as of the standard’s effective date. Businesses must disclose what their revenue figure would have been under the old guidance, so investors can make year-over-year comparisons, however.
The new rules don’t provide a prospective transition option. Adopting the changes prospectively would be easier, because companies would apply the changes only to new contracts entered into after the effective date.
Under the new rules, companies will follow five steps when deciding how and when to recognize revenues:
- Identify a contract with a customer,
- Separate the contract’s commitments,
- Determine the transaction price,
- Allocate a price to each promise, and
- Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.
In some cases, the new rules will result in earlier revenue recognition than in current practice. This is because the new standard will require companies to estimate the effects of sales incentives, discounts and warranties.
For example, under existing U.S. Generally Accepted Accounting Principles (GAAP), if a company has a contract that promises a 10% bonus for completing the work by a certain time, the bonus would not be recorded until the company met the deadline and pocketed the bonus. Under the new standard, the company would estimate the odds of collecting the bonus and recognize the revenue at an earlier date.
Where to go for guidance
The new global standard is expected to provide a universal accounting language for revenue recognition, but it relies heavily on judgment for companies to come up with their figures. This judgment can differ from company to company, country to country and CFO to CFO.
We will closely monitor how the new global revenue recognition standard is being implemented — and can provide helpful hints and considerations for applying it in your industry. Contact Dan Ward, Manager, Audit Services, today to ease your transition before the new rules go live.