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Revenue recognition issues
The new revenue standard will significantly affect the revenue recognition practices of most companies. The new standard provides a comprehensive, industry-neutral revenue recognition model intended to increase financial statement comparability across companies and industries.
Effective date and what is changing
- Sweeping changes in the FASB’s new revenue recognition model became effective Q1 2018 for most calendar year-end public business entities (PBEs), and will become effective in 2019 for non-PBEs.
- The FASB’s new model, codified in Topic 606, Revenue from contracts with customers, applies to a company's contracts with customers, except for contracts that are within the scope of other standards (e.g., leases, insurance, financial instruments). Elements of contracts or arrangements that are in the scope of other standards (e.g., leases) will be separated and accounted for under those standards.
- The IASB also published its new revenue standard in 2014: IFRS 15, Revenue from contracts with customers.
In 2016, the FASB and IASB issued several amendments and clarifications to the new revenue standard, primarily as a result of issues raised by stakeholders and discussed by the Transition Resource Group. Amendments were made to the guidance related to the principal versus agent assessment, identifying performance obligations, accounting for licenses of intellectual property, and other matters (such as the definition of completed contracts at transition and the addition of new practical expedients).
The unit of account for revenue recognition under the new standard is a performance obligation (a good or service). A contract may contain one or more performance obligations. Although defined differently, the closest analogy in today's vernacular to a performance obligation would be a "deliverable" under the multiple element arrangement revenue guidance.
Performance obligations will be accounted for separately if they are distinct. A good or service is distinct if the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer, and the good or service is distinct in the context of the contract. Otherwise performance obligations will be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct.
The transaction price is allocated to all the separate performance obligations in an arrangement. It reflects the amount of consideration to which an entity expects to be entitled in exchange for transferring goods or services, which may include an estimate of variable consideration to the extent that it is probable of not being subject to significant reversals in the future based on the entity’s experience with similar arrangements. The transaction price will also reflect the impact of the time value of money if there is a significant financing component present in an arrangement. The transaction price excludes amounts collected on behalf of third parties, such as some sales taxes.
Revenue will be recognized when an entity satisfies each performance obligation by transferring control of the promised goods or services to the customer. Goods or services can transfer at a point in time or over time depending on the nature of the arrangement. Specific criteria are provided for when a performance obligation is satisfied over time.
The incremental costs of obtaining a contract are capitalized if the costs are expected to be recovered. Costs incurred to fulfill a contract are capitalized if they are not covered by other relevant guidance, relate directly to a contract, will be used to satisfy future performance obligations, and are expected to be recovered.
Effective date: As amended, the FASB's standard is effective in 2018 (including interim periods therein) for most calendar year-end public business entities (PBEs). Non-PBEs have an additional year: the new standard becomes effective in 2019 for calendar year-end non-PBEs, and effective in interim periods in 2020 for those companies. The SEC would not object to certain PBEs (i.e., entities that are PBEs solely due to the inclusion of their financial statements or financial information in another entity’s filing with the SEC) adopting the new revenue standard using the timeline otherwise afforded private companies.
The IASB’s standard, as amended, is effective for the first interim period within annual reporting periods beginning on or after January 1, 2018, with early adoption permitted.
Transition: An entity can apply the new revenue standard retrospectively, including using certain practical expedients. Alternatively, an entity can choose to recognize the cumulative effect of applying the new standard to existing contracts in the opening balance of retained earnings on the effective date, with proper disclosures.
During a 2014 Financial Accounting Standards Advisory Council meeting, an SEC staff member indicated that the SEC will not object if companies that retrospectively adopt the revenue standard only recast the same years as presented in their primary financial statements in the five year selected financial data table (i.e., a company will not need to recast the two earliest years). However, companies that choose this option should provide transparent disclosure regarding the basis of presentation and lack of comparability.
Previous revenue recognition guidance (i.e., prior to ASC 606) lacked consistency across industries and between US GAAP and IFRS, and failed to address certain types of arrangements. The new standard is aimed at reducing or eliminating those inconsistencies, thus improving comparability, and eliminating gaps in guidance.
The new standard will significantly affect the current revenue recognition practices of many companies, particularly those that follow industry-specific guidance under US GAAP. We expect the Aerospace & Defense, Automotive, Communications, Engineering & Construction, Entertainment & Media, Pharmaceuticals & Life Sciences, and Technology industries to be impacted the most.
Depending on an entity's existing business model and revenue recognition practices, the new standard could have a significant impact on the amount and timing of revenue recognition, which in turn could impact key performance measures and debt covenant ratios, and ultimately could affect contract negotiations, business activities, and budgets.
All entities will likely have to consider changes to information technology systems, processes, and internal controls as a result of the new decision points and increased disclosure requirements, among other aspects of the model.
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