Revenue is the top line of your company’s income statement. So, it tends to receive a lot of attention from investors, lenders and other stakeholders. Why? Changes in revenue can tell whether your company is growing or declining. Moreover, changes in the composition of revenue can provide insight into your strategic plans.
If your company enters into contracts, it may need to update the way revenue is reported under new accounting guidance that goes into effect for public companies starting in 2018. Private companies get an extra year to change their reporting practices and systems to comply with this new standard.
Here are the details on what’s changing, including expanded disclosure requirements that will affect a wide range of businesses.
Prepare to Add Disclosures
What’s the biggest challenge companies encounter when adopting the new revenue recognition standard? Many companies that have already made the necessary changes report spending a significant amount of resources modifying their recordkeeping practices to comply with the standard’s expanded disclosure requirements.
Under existing U.S. Generally Accepted Accounting Principles (GAAP), most companies disclose limited information about revenue. When it comes to contract revenue, a company’s footnotes typically reveal only its general accounting policies and segment reporting.
The updated revenue recognition guidance requires all companies to provide a cohesive set of disclosures about the nature, amount, timing and uncertainty of revenue and cash flows from contracts with customers.
Specifically, the new standard will require you to:
- Break down revenue into appropriate categories, such as product lines, geographic markets, contract length and services vs. physical goods.
- Provide opening and closing balances of receivables, contract assets and contract liabilities.
- Identify various performance obligations (or promises) in the company’s contracts, including when the reporting organization typically satisfies its performance obligations and the amount allocated to the remaining performance obligations in a contract.
- Explain significant judgments and changes in judgments made when recognizing contract revenue.
The updated guidance also requires additional information about assets recognized from the costs to obtain or fulfill a contract with a customer.
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, will result in a major shift in the way some companies report revenue. For simple point-of-sale retail transactions, little change is expected: Revenue will continue to be recognized when goods or services are delivered to the customer. The process gets more complicated for long-duration, multi-element contracts, sales that include incentives for customers with poor credit, and contracts with built-in discounts or performance bonuses.
The breadth of change under the new standard depends on your industry. Companies that currently follow industry-specific revenue recognition rules under U.S. Generally Accepted Accounting Principles (GAAP) will feel the biggest effects from these changes. Examples include software manufacturers, telecommunications companies, defense contractors, airlines, hospitality and gaming companies, and health care providers.
Nearly all companies will be affected by the expanded disclosure requirements, which call for more details on the composition of revenues. (See “Prepare to Add Disclosures,” at right.)
Exceptions to the new rules include insurance contracts, leases, financial instruments, guarantees and nonmonetary exchanges between entities in the same line of business to facilitate sales. These transactions remain within the scope of existing industry-specific GAAP.
Compared to current practice, the updated guidance requires management to make more judgment calls based on overriding principles. The new standard calls for five steps to decide how and when to recognize revenue:
- Identify a contract with a customer.
- Separate the contract’s “performance obligations” (discrete promises to transfer goods or services).
- Determine the transaction price.
- Allocate the transaction price to each performance obligation.
- Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.
Essentially, the updated standard requires companies to assign a transaction price to each of a contract’s separate performance obligations and consider whether it’s “probable” they won’t have to make a significant reversal of revenue in the future. They also may need to adjust transaction prices to reflect the time value of money. Different companies may interpret the “probable” threshold differently, however, threatening financial statement comparability among entities.
It’s important to note that the new standard doesn’t change the total amount of revenue your company reports. Rather it’s a matter of timing. Companies may report revenue sooner (or later) under the new standard, depending on the terms of their contracts and management’s application of the “probable” threshold.
Use of Estimates
Recognizing revenue under the new standard will require management to make subjective judgment calls on such issues as:
- Identifying performance obligations,
- Estimating standalone transaction prices for distinct goods and services, and
- Evaluating variable consideration (such as rebates, discounts, bonuses and rights to return) when determining the transaction price.
As the start date approaches, it’s important to assess whether the use of estimates could expose your company to additional financial reporting risks. The Securities and Exchange Commission’s Office of the Chief Accountant is urging public companies to conduct a risk assessment to ensure that they meet their financial reporting responsibilities under the new standard. The implementation process may include adopting new internal controls to help prevent management bias and inadvertent errors that could mislead stakeholders about contract revenue.
In light of the increased risk of potential misstatements, expect more questions from your accountant regarding revenue. If your statements are audited, expect your auditor to request more documentation and perform different auditing procedures than in previous years. Also, understand that the new rule may result in temporary book-to-tax reporting differences. That’s because the tax rules regarding revenue recognition haven’t yet changed to jive with the new accounting standard.
If your company issues comparative financial statements under GAAP, you should have already started the process for adopting the new revenue recognition standard. Most public companies that have already made the changes report that it takes more time and effort than they initially expected.
Contact your accounting professional to determine the extent to which the guidance will affect your company and how to revise your recordkeeping procedures, accounting systems and internal controls to facilitate compliance.