Effective January 1, 2019, private companies are required to comply with Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The new standard results in a five-step process to follow when recording revenue:
- Identify the contract
- Identify separate performance obligations
- Determine the transaction price
- Allocate the transaction price to performance obligations
- Recognize revenue as or when each performance obligation is satisfied
As we’ve worked with clients over the past year to implement the new standard, overall many of them have found that certain revenue streams or contracts they thought would be relatively easy to analyze have taken a few more steps, and time, than anticipated. But with any far-reaching ASU there is always a lot to process and much to learn. Below are a few of the initial lessons we have learned along with our clients while helping them through their implementation journeys.
1. Gathering Data Takes Time
While this may seem obvious, there’s a lot of data available, and the process of gathering the RIGHT information can take significantly longer than expected. Accounting departments have learned they need to talk to many other departments within their company to gather this data and get a deeper understanding of the revenue contracts, so they can properly identify performance obligations and transaction pricing. Often those discussions are including sales, information technology, customer service, legal and purchasing.
2. “Promo” Goods and Services May Complicate Matters
If a customer enters into a contract and has the option to receive discounts or free goods in the future, a company must determine whether there needs to be a bifurcation of revenue based on standalone selling prices in relation to these future options, which the guidance calls “material rights.” If the material right relates to a renewal period, then the company must address whether a material right is a contract continuation or contract modification. So what may have been a simple marketing promotion has now turned into a time-consuming process to determine how to properly record revenue using the new five-step process.
3. “Over Time” Contracts Require New Thinking
Companies are required to recognize revenue over the life the contract (rather than a point in time) when there is no alternative use for the good or service and there is an enforceable right to payment for performance to date. Manufacturers who have contracted to sell a customer fixed quantities of a customized product over time may find themselves manufacturing inventory early in the contract period due to favorable market prices of inputs (steel, for example), but not shipping until the customer requires the inventory. This may be preferable from an operational perspective, but, from an accounting perspective, companies are seeing a change in how they record their revenue in relation to these contracts. Where they were recording revenue upon shipment of product, they may now be recording it based on performance completed to date. Companies may now have to budget for revenue differently, and this is a significant change in mindset.
4. Pre-Production Costs May or May Not Fall Under ASC 606
We have received questions as to whether customer reimbursement of pre-production costs, such as tooling, falls under the new revenue recognition standard ASC 606. And the answer is, it depends on the facts and circumstances underlying the specific arrangements. Companies should consult with their accounting service team to determine whether these would fall into a revenue stream that would need assessed under ASC 606.
5. Costs Associated with Obtaining a Contract Are Important
To obtain a contract, a company may incur incremental costs it would not have otherwise incurred. If a company expects to recover these costs, it should record them as an asset unless it would be amortized over one year or less. Upon entering into a contract, some companies are currently identifying as assets certain obligations and payments to their salesforce, outside consultants and even vendors. It’s important to look to the available guidance to know how to accurately account for these costs. Companies are now realizing the importance of assessing contract costs in addition to recognizing revenue.
6. Find the Right Transition Method for Your Company
Private companies still have time to determine which method they will be implementing when they prepare their 2019 financial statements:
- The full retrospective method, in which you would retrospectively adjust your financial statements to each reporting period presented for the new standard, OR
- The modified retrospective method, in which you would retrospectively adjust your financial statements with a cumulative effect recognized at the date of initial application through equity as of January 1, 2019.
More companies are leaning toward the modified retrospective method. However, before deciding, companies need to ask the question, ‘Will users expect or want to see comparative financial statements or single-year financial statements for 2019?’ Talk with your stakeholders and collaborate with your accounting service team to assist you in determining which transition method is best for your company.
7. Software Companies Will Recognize Revenue Upon License Transfer
Certain industries, such as technology and namely software companies, may have been recognizing revenue on a straight-line basis resulting from time-based term contracts with their customers. These companies preferred this method of revenue recognition because it provided them with easy to understand ratable revenue recognition and simplified the budgeting and forecasting for management and external stakeholders. The guidance under ASC 606 now requires these companies to generally recognize revenue upon the transfer of control of a software license to the customer. This will accelerate revenue to a single point in time, rather than being recorded over time as it was previously. This has created budgeting and forecasting issues for management, and the choppiness in revenue, gross margins and earnings has made it difficult for stakeholders to compare revenue to prior periods. Management teams should already be determining the effects of adopting ASC 606 and educating stakeholders regarding all of the impacts.
These are some of the key lessons coming to light after almost a full year of implementing the new revenue standard, and we expect there certainly will be more. Implementing such an expansive new standard may seem daunting, but the sooner your company prepares the better off it will be moving forward.
Please contact a member of your service team, or contact Tina Dzik at email@example.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.