“The Perfect Accounting Storm” is Coming: Is your Company Ready?
Smit Shah, CPA
09.13.2018 | Berdon Industry Insights
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 revenue recognition standard — Accounting Standards Codification (ASC) 606.
The new standard took effect for publicly held companies for annual reporting periods after December 15, 2017, whereas for privately held companies it will be effective for annual reporting period after December 15, 2018 and interim reporting periods within annual reporting periods beginning after December 15, 2019. Currently, reports indicate that implementation has been—in the words of Hortonworks CFO Scott Davidson—“a heavy lift” that has been costly and has required changes in systems and internal and external reporting.
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.
Is your company ready?
The Five Steps of ASC 606
According to the Financial Accounting Standards Board (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.
In order to comply with the new revenue recognition standard, 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.
ASC 606’s impact on the Hospitality Industry
Since we have covered the basics, we will move to how applying the new standard plays out for companies within the hospitality industry.
First, the good news. Food and beverage revenue recognition will not be affected by the new standard.
The following, however, will be affected by ASC 606:
Generally, standard franchise agreements contain the following promised goods or services and provide for initial franchise fee and recurring franchise fees:
- License to the franchisor’s intellectual property
- System assessment services, such as marketing and reservation activities
- Preopening services
Note: Revenue recognition guidance for hotel management agreements under ASC 606 is similar to the guidance for franchise agreements. Incentive fees, which are generally reflected in a hotel management agreement, are recognized when it is probable that a significant reversal in the cumulative amount of recognized incentive fees would not occur.
(a) Initial Franchise Fee
The initial franchise fee is paid for the preopening services provided by the franchisor.
Under current generally accepted accounting principles (GAAP), the initial franchise fee is recognized when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor. Commencement of operations by the franchisee is presumed to be the earliest point at which substantial performance has occurred, unless otherwise demonstrated.
Under ASC 606, the franchisor should determine whether preopening services provide a service that is distinct from the license, which will require judgement and may vary based on the individual contract needs and the franchisor’s customary business practices. Most franchisors will generally conclude that the franchisee cannot benefit from the preopening services on its own without the use of the license and, as such, is highly dependent and interrelated with the license. In this situation, the initial franchise fee will be recognized over the term of the franchise agreement, which is a significant change from current GAAP.
(b) Recurring Franchise Fees
Generally, recurring franchise fees include royalty fee, marketing fee, and reservation fee.
Under ASC 606, recurring franchise fees are recognized as revenue as fees are earned and become receivable from the franchisee. Typically, these fees are based on a percentage of revenue and, therefore, recognized at month-end when the revenue is known, which is similar to revenue recognition under current GAAP.
(a) Room Revenue from Online Travel Agencies
There will be significant changes in how hotels will account for revenue from online travel agencies (OTAs) under ASC 606. Under current GAAP, there are two models used to capture revenue from OTAs—the Retail or Commission Model (gross basis) and the Merchant Model (net basis).
Since a hotel is primarily responsible for providing stay and services, has inventory risk and determines the room rates, the revenue needs to be recognized on a gross basis under ASC 606. This is a significant change from current GAAP, as it will affect many expenses that are based on a percentage of revenue (e.g., management and marketing fees).
(b) Room Revenue under Non-cancellable Reservations
Under ASC 606, the transaction price would be recognized as revenue evenly over the hotel stay for non-cancellable room reservations. Under the current practice followed by hotels, room revenue for each day is recognized based on the room rate for that day. Therefore, the new standard will affect revenue recognition when the non-cancellation room reservation covers two accounting periods (for example, a non-cancellable room reservation for four nights with check-in on December 30, 2018 and check-out on January 3, 2019 that has different room rates for each night).
In many cases, a large portion of gift cards is not redeemed. Can–or should–companies account for revenue from gift card “breakage”?
Current GAAP does not provide any specific guidance. However, the U.S. Securities and Exchange Commission (SEC) staff has provided two acceptable methods to recognize breakage revenue:
- Specific Identification Method – Breakage revenue is recognized when the chance of a specific gift card being redeemed becomes remote. The SEC does not specify how long the entity should wait before recognizing breakage revenue; however, the common practice is to wait two years.
- Homogenous Pool Method – The entity needs to estimate the proportion of a pool of gift card value that will be unredeemed over the estimated useful life of the cards, and recognize breakage revenue in proportion to the amount redeemed over the useful life of the cards within the pool.
According to ASC 606 and Accounting Standards Update (ASU) 2016-04 guidelines, to the extent gift card breakage is not subject to unclaimed property laws, an entity will need to consider guidance relating to variable consideration constraint, as well as historical data, in order to conclude that a significant reversal in the cumulative amount of recognized breakage revenue will not occur. If the criteria for variable consideration constraint are met, the entity will recognize breakage revenue in proportion to redemptions. This is similar to the homogeneous pool method noted above. If the criteria for variable consideration constraint are not met, breakage revenue is recognized when the likelihood of the customer redeeming the gift card becomes remote.
How will ASC 606 affect accounting for revenue from hotel loyalty programs? Under current GAAP, there are two approaches to account for revenue from loyalty programs—the Incremental Cost Model and the Deferred Revenue Model (also known as the Multiple-Element Model). The guidelines under ASC 606 are broadly consistent with the Deferred Revenue Model. For instance, under ASC 606:
- Companies will need to determine if the option for free or discounted ancillary services contains a material right and is, itself, a separate performance obligation. If so, the transaction price should be allocated to each performance obligation.
- The estimate for the option for free or discounted services should be based on the discount that the customer would receive when exercising the option, and the likelihood that the option would be exercised.
- Companies should recognize revenue when those future goods or services are transferred or when the option expires.
It cannot be emphasized enough that the changes required by ASC 606 are far-reaching. With only a few months to go before ASC 606 comes into effect for privately held companies, now is the time to act.
To learn more about the new revenue recognition standard and how it will impact your business, contact Smit Shah at 212.331.7493 | email@example.com or speak to your Berdon advisor.