In 2016, the Financial Accounting Standards Board (FASB) issued accounting updates on two significant topics: revenue recognition and lease accounting. Companies should begin to plan now how to incorporate the new standards and update procedures.
In 2014, FASB and the International Financial Reporting Standards (IFRS) converged to issue a standard for revenue recognition that would increase comparability across industries. This new standard marked a significant change and was meant to reduce complexity and standardize revenue recognition regardless of industry.
Many perceived the prior guidance, which varied under Generally Accepted Accounting Principles (GAAP) and IFRS, to be too complex and inconsistent among industries. Companies had to meet different requirements depending on the industry or type of transaction.
FASB’s new guidance will address inconsistency and weakness in the existing revenue requirements, create a new framework to address revenue issues, improve comparability across entities and industries, provide more information and improved disclosure on financial statements and simplify the preparation of financial statements by reducing the number of requirements. The new revenue recognition guidelines are premised on the following principle:
Recognize revenue in a manner that depicts the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.1
The rule is effective for public companies for the first interim reporting period for fiscal years beginning after December 15, 2017. Non-public companies have an additional year and will begin adopting after December 15, 2018. The changes are significant and in many cases expected to allow companies to recognize revenue earlier. It will take time for companies to adopt and transition to the new standard. For most, the transition has already started, and entities that have not begun the transition process are running out of time to properly complete the necessary steps.
Following are the FASB revenue recognition steps:
- Identify the contract with the customer. Other arrangements such as leases will be accounted under different standards (see below).
- Identify the performance obligations. Performance obligations are the promises or deliverables in the contract. They can be accounted for separately if the goods or services are distinct. An obligation is distinct if the consumer can benefit from it on its own.
- Determine the transaction price. The transaction price needs to be allocated to each of the separate performance obligations in the contract. It should reflect the amount of payment one could expect in exchange for the delivery of goods or services.
- Allocate the transaction price to the performance obligations in the contract. If there is more than one obligation, then the transaction price should be allocated to each obligation identified in the contract.
- Recognize revenue when (or as) the reporting satisfies the performance obligation. This happens when control of the promised good or service is transferred to the customer.
Implementing the New Revenue Recognition Approach
As companies implement this new approach to revenue recognition, they need to focus on the following:
- Develop and implement the appropriate processes and controls.
- Work with information systems to adopt the new standard and change processes to reflect the new revenue recognition model.
- Analyze any needed change to pricing strategies.
- Revise any measures tied to revenue such as sales incentives, debt covenant ratios or compensation plans.
- Work with auditors to review these new processes and controls. Allow enough time for both auditor review and revision. It is important to bring auditors in early as they will need to agree with how you plan to allocate revenue to each step in the revenue recognition process.
- Seek to understand the likely impact on financial results.
- Be prepared to communicate the likely impact both internally and externally.
In practice, we anticipate the new rules will have several implications.
- There could be an unexpected impact on a company’s post-transaction statements from valuation of deferred revenues and the implied reduction.
- Some industries will encounter more challenges through revenue recognition than others. A consumer goods producer that manufactures and sells a product is unlikely to see a significant impact. Others, such as technology companies, have ongoing obligations including support services. For these companies, the new rules will have potentially significant implications on the timing as performance obligations may cover an extended period of time.
- Expect audit staff to scrutinize and possibly challenge the revenue recognition model. VRC anticipates many companies will need to go through several rounds of review to develop an acceptable approach.
- Some companies may see an adoption-year impact of increased or decreased revenues. This should even out over time.
FASB and IASB created a joint transition resource group for revenue recognition. Practitioners can visit the resource group to learn more.
In early 2016, FASB issued an Accounting Standards Update related to the financial reporting of leasing transactions. Many companies are transitioning to the new rules. Under the new standard, companies will include leased assets and the related obligation on their balance sheets, in addition to classification changes to the income and cash flow statements.
FASB implemented the new standard to respond to requests from investors and financial statement users for a better representation of an organization’s leasing activities and transactions as well as to end what the SEC and some stakeholders believe can be a form of off-balance sheet accounting.
The new model affects both financing leases (like the current capital lease) and operating leases. It will not only change the lessee accounting for all leases, but it will also impact how financial statements will be presented and affect key financial metrics such as debt covenants or performance indicators tied to compensation.
The effort involved in the adoption of this new leasing standard should not be underestimated. The identification of all leasing arrangements for many companies will be a large exercise involving judgment and robust data collection. In addition, the new accounting standard may require changes to systems and the related control environment. It is also likely to affect financial statements and could impact the way investors analyze a company’s financial condition and operating results.
FASB established their intended adoption date to be required for fiscal years and the related interim periods beginning after December 15, 2018 with retroactive application to the previous two fiscal years. This means companies should have complete adoption effective January 1, 2019 and retroactive application to 2017 and 2018 for both annual and interim financial statements. For non-public companies, the required adoption date is for fiscal years beginning after December 15, 2019. Early adoption is permitted upon issuance of the new standard.
Changes to revenue recognition rules will likely result in the continuing evolution of valuation approaches for the resulting haircut to deferred revenue and the assigning of value to separately identified performance obligations. For a more in-depth conversation about these valuations or how VRC can help develop an assessment for your business, please feel free to contact the article author or your VRC professional.
1 FASB Outlook, 2014 Q1 Issue; What You Need to Know About Revenue Recognition, FASB.org