Is Revenue Recognition Wrecking You?

The biggest accounting standards update ever has private companies scrambling to comply with new revenue recognition and reporting standards. By LISA WILDER | Summer 2018



If you have clients who run private companies, you might want to ask them to clear some time on their calendar this summer — and fall, probably. They’re going to need plenty of time to digest ASC 606, “Revenue From Contracts With Customers.” And you might too.

At over 700 pages, including more than a few amendments, the landmark revenue recognition standard update is not only lengthy, but depending on the company, potentially burdensome. The new revenue recognition standard is not an incremental change to what public, private, and not-for-profit companies were already doing — it’s a new approach that, according to Deloitte, frees up “organizations to apply reasoned judgment and enterprise-specific context rather than highly prescriptive rules.”

“This new standard is radically different than any new accounting standard entities have ever had to deal with,” says George M. Wilson, director of the SEC Institute, a specialist in SEC compliance and accounting education. “Previous standards have had to do with how to make journal entries, which is reasonably objective. This new standard is broad and principles-based — many have started out looking for detailed rules only to find out there aren’t any. It’s about finding out how these principles apply to each individual business.”

For most companies, this means breaking down the choreography of their entire revenue recognition process — changes can go well beyond an organization’s finance, tax, and audit functions to force a major heal turn in future production, marketing, and sales processes. Yes, it’s that big.

It’s all about understanding the new standard and how it fits the business, then building a new revenue recognition process. And if neither you nor your clients have focused on this new standard yet, it’s time. At the very least, there’s a lengthy learning curve.

Most private companies will have to do an in-depth analysis of every combination and permutation of their customer contracts to determine how revenue is earned today and whether that might change to ensure they’re ready to apply the revenue recognition standard for annual reporting periods beginning on or after Dec. 15, 2018 (which equates to Jan. 1, 2019 for private entities with a Dec. 31 year-end), and interim reporting periods within annual reporting periods beginning after Dec. 15, 2019. (Public companies were required to adopt the new revenue recognition standard on the same dates last year.)

In other words, if you’re not knee-deep in review and preparation, you need to be. Nearly every company will be affected in some way, but experts say the most analysis and potential change will happen in the software, construction, healthcare, technology, life sciences, and entertainment industries.

Microsoft, for example, made waves last year by declaring it would adopt the new revenue rules early and adjust previously reported financial results for 2016 and 2017 based on a decision to book its revenue upfront for its sales of Windows 10 software to original equipment manufacturers rather than booking the revenue over a period of time as an ongoing service. Electric car maker Tesla also stirred headlines, and the markets, with news that accounting under the new revenue recognition standard reduced its earnings shortfall and allows for faster recognition of leased car revenue.

Proponents say the new revenue recognition standard is great because it will make topline activity in all companies — but particularly in public companies watched by investors — more transparent because many businesses have backlogs or revenue not yet recognized from contracts already signed. Still, many companies will have to revise those values and/or dates, which will make for reported earnings volatility as companies adjust their practices.

But before we go farther, how did we get here?

The Background

In 2014, after an extensive review that finally united the long-dueling revenue treatment under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), a new standard of revenue emerged, which the Financial Accounting Standards Board (FASB) and its international counterpart, the International Accounting Standards Board (IASB), pledged would “improve the financial reporting of revenue and improve comparability of the top line in financial statements globally.”

Previous U.S. GAAP and IFRS revenue recognition requirements differed and led to different accounting outcomes for transactions that were economically similar. As FASB describes it, IFRS revenue recognition requirements “lacked sufficient detail” while U.S. GAAP went the other way — “overly prescriptive and conflicting in certain areas.”

The new standard addresses something else that’s important — the digital revolution in global commerce. Many experts believe it was time for a revenue standard that could accurately measure revenue recognition across developing industries and contracts signed with a keystroke on a smartphone. In other words, it allows organizations to measure revenue as their products and payment systems evolve. But it will take substantial work at the beginning.

“Is this wrecking business? No,” says Kurt Oestriecher of Alexandria, La.- based Oestriecher and Co. CPAs. “The standard provides a five-step process for determining the timing of when to recognize revenue. Because the standard is principles-based, not every situation will be addressed. In those instances, companies now have a framework that requires them to be more consistent in their revenue recognition practices. This is not the horrible thing it’s been made out to be.”

The Guidance

The new revenue recognition standard affects all entities — public, private, and not-for-profit — that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (think leases and insurance contracts). Financial instruments, guarantees (other than product or service warranties), and nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers are also detailed. The core principle is “an entity should recognize revenue to depict 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.”

While that’s a mouthful, the standard’s guidance offers a five-step process to determine when and how much revenue should be recognized. The AICPA condenses these steps in its Financial Reporting Brief: Roadmap to Understanding the New Revenue Recognition Standards. Here’s a high-level overview:

Step 1. Identify the contract(s) with a customer. This is a critical step considering an entity must account for contracts with customers that meet certain prescribed criteria.

Step 2. Identify the separate performance obligations in the contract. A performance obligation is defined as “a promise in a contract with a customer to transfer a good or service to the customer.”

Step 3. Determine the transaction price. The transaction price is “the amount of consideration (for example, payment) to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.” To determine the transaction price, an entity should consider not only the terms of the contract but also customary business practices and a slate of other criteria.

Step 4. Allocate the transaction price to the performance obligations. The guidance states that “if a contract has more than one performance obligation, an entity should allocate the transaction price to each separate performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each separate performance obligation.”

Step 5. Recognize revenue when or as the entity satisfies a performance obligation. Accordingly, “an entity should recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. An asset is transferred when (or as) the customer obtains control of that asset.”

Consider Chicago-based Reynolds Group Holdings Limited, a privately held manufacturer of consumer beverage and foodservice packaging — including the Starbucks cup you might have picked up on the way to work this morning. Let’s stick with that cup.

Like most manufacturers, Reynolds historically recognized revenue at shipment. However, the new revenue recognition standard spurred a two-year review process of the company’s contracts with customers that warranted a different approach.

“When we put the Starbucks name on a cup, we don’t have the ability to sell that cup to another customer. We have no alternative use for that product. So, we have the right to payment at the time of manufacture, not shipping, based on our contract language,” explains Rich Tarapchak, Reynolds’ corporate controller and an Illinois CPA Society member. “You have to check your contract language very closely against the guidance, and sometimes that requires you to recognize revenue sooner.”

The Deadline

You have the deadline. You have the standard. But how do you adopt and implement it in time? Wilson thinks white papers help — not the kind you download but the kind you write yourself.

“It’s about choosing a couple of key contracts and determining how the new principles apply to them,” Wilson says, noting that he’s seen self-authored documents ranging from 20 pages up to an 80-page whitepaper authored by an agricultural equipment maker on key contractual issues.

The point? To literally go through the thought process and document how your business functions and how the new standards operate within your enterprise. “It’s a way to explain your thought process to your auditors or outside consultants,” Wilson explains. “I did a workshop last summer sponsored by an auditor with 12 private companies in attendance, and they were startled by this. Usually it takes anywhere from three to seven months to manage the transition.”

Wilson offers three steps for getting your arms around the process:

1. Take time to get familiar with the new standard, either alone or with expert help. “I would allow one to two days to do this because everything you know about revenue recognition is gone. It’s a fresh start,” he says.

2. Pick a revenue stream (or two) to analyze. “Take the time to apply what you’ve learned directly to one of your revenue streams. Get an example going and work it through,” Wilson says. “It’s not until you do this that you really understand the extent of the change.”

3. If you need further help, secure it ASAP. Figure out what resources you’ll really need to execute the full extent of the revenue recognition transition within your operation, whether that means bringing in legal, tax, audit, or industry-specific accounting help.

There’s a parallel learning process for accounting professionals serving clients, according to Ralph Nach of Chicago-based Epstein + Nach LLC, a financial reporting consulting and training firm:

• Get instruction immediately to save time. “If you haven’t gone to at least a full-day seminar, you’re going to waste time trying to master the content on your own,” Nach says, referencing the many pages of guidance on the new standard, much of it amended very late in the process. “It’s more efficient to take a seminar or course to get up to speed and ask the questions relevant to the industry group or groups you serve,” he says.

• Inform your clients now. “Talk [to them] about steps they’ll need to take to comply on time and whether they need additional resources to allow their auditors to maintain their independence,” he suggests, cautioning that outside consulting services may be needed, and as Jan. 1, 2019 gets closer, those resources will become scarce and expensive.

• Analyze data needs. Conduct an analysis of what data will need to be generated for proper documentation of accounting judgments and for accommodating the newly required disclosures. Accessing the information needed for proper disclosure should be the focus now, and “process and systems design can come later,” Nach says.

One last point. Wilson says accounting professionals and their clients should buckle down and learn the new revenue standard now because another hurdle is coming — new lease accounting standards, which promise to drastically change how public and private companies account for leases on everything from office space to copiers.

The document-by-document approach to contracts will have to be repeated on the lease side and shouldn’t be underestimated. “It’s going to involve all your little leases, like copiers, machine tools, fiber optic cables, or cars for executives; anything you rent to get business done,” Wilson says. “That’s the next thing to look forward to!”