New Revenue Recognition Standard for the Manufacturing Industry
Published in 2014, the Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), is effective now for most public companies. For private companies, the new update will go into effect on January 1, 2019. The new standard calls for a single, five-step model by which most companies worldwide must recognize revenue under U.S. Generally Accepted Accounting Principles (GAAP). The implementation process will vary from industry to industry, often depending on the complexity of customer transactions.
The principle behind the new revenue recognition standard holds that companies recognize revenue when goods or services are transferred to a customer. The amount of revenue recognized should represent the consideration “to which the company expects to be entitled.” The goal of the new standard is to provide one broad principles-based method for businesses to utilize across the board, as opposed to different versions of industry-specific guidance.
Accounting professionals in the manufacturing industry may find that the new standard requires a reexamination of their accounting functions and a closer application of judgment. Adopting the new standard will be a significant undertaking, and the impact will likely extend far beyond just the finance and accounting teams. Companies may change operating practices or parts of contracts to more clearly and accurately align with the new standard.
Two methods of transition
The new standard outlines two methods of transition upon adoption: the full retrospective method or the modified retrospective method. Under the full retrospective approach, all reporting periods presented are reported under the new standard, and you are required to disclose any prior period information that has been adjusted. This approach, while requiring more effort, will provide comparative financial statements.
In the modified retrospective approach, only the initial period of adoption needs to be reported under the new revenue model. Other periods would remain presented under existing GAAP. While financial statements will not be comparative under this method, it will be simpler, as it only requires one cumulative adjustment.
This is the five-step model businesses will use to correctly determine revenue recognition:
- Identify the contract with a customer. A contract is an agreement that creates enforceable rights and obligations. Contracts now have several criteria they’re required to meet.
- Identify the performance obligations in the contract. Performance obligations are promises in a contract with a customer to transfer goods or services. Goods or services count as performance obligations if they are distinct or a bundle of goods and services that is distinct.
- Determine the transaction price. The transaction price is the amount of consideration to which a company expects to be entitled in exchange for transferring goods or services to a customer.
- Allocate the transaction price to the performance obligations in the contract. The transaction price should be allocated to each performance obligation in an amount that depicts the amount of consideration the company expects to be entitled. Transaction prices should be allocated on a relative stand-alone selling price basis.
- Recognize revenue when the entity satisfies a performance obligation. Once steps 1 through 4 have been completed, revenue can be recognized when performance obligations are satisfied.
Special considerations for manufacturers
Manufacture of custom goods. Sometimes custom goods are manufactured for customers that can’t be repurposed for other uses by manufacturers. In those instances, revenue should be recognized throughout the manufacturing process based on percentage of completion if the customer guarantees payment for performance completed to date.
Variable consideration. The total transaction price of a contract includes both fixed and variable consideration. Variable consideration can either be positive or negative adjustments to the transaction price. Examples of positive variable consideration are per-unit costs ($10 per 100 widgets delivered) and early completion bonuses. Examples of negative variable consideration are volume discounts, rebates, price matching and index pricing. Regardless of the amount of variable consideration estimated, the total transaction price must be low enough that a significant reversal of revenue recognized will not occur in the future.
Combining contracts. If multiple contracts are entered into at or near the same time they should be accounted for as a single contract if any of the following criteria apply:
- They are negotiated as a package with a single commercial objective.
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
- The goods or services promised in the contracts are a single performance obligation.
Control. A manufacturer should recognize revenue when they satisfy a performance obligation. An asset is transferred when the customer obtains control of that asset. Control has transferred if the customer can direct the use of and obtain substantially all the remaining benefits from the product. This can occur even before shipment or delivery, depending on the contract language.
Options. If the purchase of certain goods grants the customer a material right toward future purchases, either in the price or availability of goods, a portion of the transaction price shall be allocated to the option. The option revenue is recognized when exercised by the customer or when expired.
Contract costs. The incremental costs of obtaining a contract (commissions) can be recognized as an asset and amortized only if they are expected to be recovered. As a practical expedient, such costs can be expensed as incurred if the amortization period is less than one year. If selected as an accounting policy, this should be applied consistently to similar contracts.
Shipping. Shipping and handling services may be considered a separate performance obligation if control of the goods transfers to the customer before shipment, but the entity has promised to ship the goods. In contrast, if control of a good does not transfer to the customer before shipment, shipping is not a promised service to the customer and can be treated as a fulfillment cost through an accounting policy election.
Contract modifications. Contract modifications are changes in the scope and/or price of a contract that is approved by the parties to the contract. Contractors should treat change orders one of three ways, depending on the situation:
- Create a separate contract if the modification results in a separate performance obligation and the consideration to be received reflects the standalone selling price.
- Account for the modification through a cumulative catch-up adjustment if the additional or remaining goods aren’t distinct.
- Account for the modification prospectively if the additional goods added to the contract increase the total contract price at standalone selling prices.
Loss contingencies. The accounting for loss contracts was excluded from the scope of the new revenue recognition guidance, so the existing requirements in this area still apply.
Warranties. Optional warranties purchased separately by the customer are treated as separate performance obligations. However, if the warranty is an assurance-type warranty (against defects), there is no distinct performance obligation.
Disclosures. Nearly all companies will be affected by the expanded disclosure requirements. Several disclosures will be required, regardless of which transition method your company chooses. Some of these disclosures include:
- Disaggregated revenue
- Reconciliation of contract balances
- Performance obligations
- Costs to obtain or fulfill a contract
- Practical expedients
- Transition disclosures
Adopting the changes under the new revenue recognition standard will be time-consuming and complex. This will likely include more closely evaluating the accounting for customer contracts, implementing new financial reporting systems and upgrading financial reporting controls to deter fraud. It will also require more coordination between accounting departments and operations. Contact us with any questions about putting procedures in place or to discuss the latest developments from the Financial Accounting Standards Board (FASB).