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?
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:
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.
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.
Impact on the Manufacturing and Distribution Industry
Since we have covered the basics, we will now look at how these new standards play out in practice—from customer contracts to warranties—for businesses within the manufacturing and distribution industry.
The first thing to keep in mind is that while the new revenue standards apply to all customer contracts, they will not affect financing arrangements, insurance contracts, or leasing agreements, which are already covered under existing FASB and IASB standards. However, the new revenue recognition standards will apply to contract modifications, such as a change in the scope and/or price of a contract that is approved by the parties to that contract.
Under current generally accepted accounting principles in the United States (GAAP), little guidance is provided on how to account for changes in contracts. The primary change under ASC 606 is that a contract modification may now be treated as a separate contract, when both the scope and price of the contract are increases for distinct goods and services which are added to a contract at the vendor’s stand-alone price.
ASC 606 does away with the “sell-through” method that was commonly used under GAAP to account for variable consideration (i.e., how discounts, credits, rebates, refunds, or price concessions can affect transaction price).
Under ASC 606, businesses will use either the “expected value” or the “most likely amount” approaches, allowing manufacturers to account for revenue from distributors earlier than would have been under the “sell-through” method, whereby manufacturers had to wait to record revenue until their products were sold to end-users.
Products are often sold with warranties that promise protection in the event they are defective during a set time frame after the customer’s initial purchase. Under the new revenue recognition standards, manufacturers will be required to distinguish between assurance warranties (i.e., those that provide a guarantee that the product will work) and service warranties that represent a potentially additional service the manufacturer must provide to the customer (i.e., an extended warranty that provides the customer with a repair guarantee should the item malfunction).
Under current GAAP, warranties that are not independently priced are generally not accounted for separately. Under ASC 606, a distinction must be made between warranties that obligate the manufacturer to provide an additional service (i.e., service warranties), which must be accounted for separately, and assurance warranties, which do not.
Enough emphasis cannot be placed on the fact that the changes required for ASC 606 are far-reaching. With only a few months to go before the new revenue recognition standards go into effect, now is the time to act.
To learn more about the new revenue recognition standards and how they will impact your business, speak to your Berdon advisors.