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Revenue Recognition

The biggest change to accounting rules in over a decade is on the horizon and most privately owned businesses may not be prepared for new converged revenue recognition standards, Accounting Standards Codification, Revenue from Contracts with Customers (ASC 606), and International Financial Reporting Standard (IFRS) 15.

Is your company ready?

Background Briefing

After 12 years of collaboration, the Financial Accounting Standards Board (FASB) and European counterpart, the International Accounting Standards Board (IASB), realized that there were significant differences in the way each accounted for revenue and that both systems of revenue recognition needed improvement. As a result, the FASB and IASB determined that both systems would benefit from fewer inconsistencies, as well as standardization across industries and jurisdictions, with the issuance of converged revenue recognition standards ASC 606 and IFRS 15, in September 2014. 

The FASB and IASB set forth five goals for the new standards:

  • Removal of inconsistencies and weaknesses in revenue requirements.
  • Delivery of a more comprehensive framework for addressing revenue issues.
  • Comparability improvement of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
  • Provision of more useful information to financial statements users, through improved disclosure requirements.
  • Simplification of the preparation of financial statements, by reducing the number of requirements to which an entity must refer.

According to the FASB, the new standard’s core principle is that an entity should recognize revenue to depict the transfer of promised 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.  The new standards took effect for publicly held companies for annual reporting periods after December 15, 2017. Currently, reports indicate that implementation has been, according to Hortonworks CFO Scott Davidson, “a heavy lift” that has been costly and has required changes in systems and internal and external reporting. 

Why?

The FASB and IASB efforts to streamline the process of tracking revenue was in need of standardization, given the variables involved (differing subscription models, warranties, product and service bundling, rebates, and termination fees, just to name a few).  The FASB explains that previous revenue recognition guidance consisted of broad revenue recognition concepts with numerous requirements for different industries and transactions. The new standardization makes it easier to compare reported revenue on financial statements across companies and decreases the differences in accounting for economically similar transactions.

Nonpublic companies should apply the new revenue standards to annual reporting periods after December 15, 2018, as well as for interim reporting periods within annual reporting periods after December 15, 2019.  These accounting changes are reputed to be the most significant accounting reforms since the Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act of 2002, wherein the major difference is that Sarbanes-Oxley applied only to publicly held corporations and these new standards encompass private companies.

Since the new standards directly affect revenue—the lifeblood of every company—they will have a significant impact on financial statements, and potentially, your bottom line.

In addition to the toll that implementation of these standards will have on compliance and accounting departments, there is potential for the impact to extend to legal and human resources, as well as sales, marketing, and IT departments.

The Five Steps of ASC 606

In order to comply with the new revenue recognition standards, companies should take the following steps:

Step 1:  Identify the contract(s) with a customer.

Step 2:  Identify the performance obligations in the contract.

Step 3:  Determine the transaction price.

Step 4:  Allocate the transaction price to the performance obligations in the contract.

Step 5:  Recognize revenue when or as the entity satisfies a performance obligation.

Additionally, when transitioning from ASC 605 / SAB 104 to ASC 606, it is essential for companies to review their existing sales contracts to ensure that they are legally enforceable.