The rocky road to new revenue standards
Most financial statement users agree that revenue is one of the most important financial measures. It is also the area that is most confusing and disparately regulated, and the source of most financial restatements and enforcement actions.
It is why in the movement towards getting U.S. GAAP (Generally Accepted Accounting Principles) on the same page as the rest of the world - the joint work between the Financial Accounting Standards Board and the International Accounting Standards Board to arrive at consensus on worldwide standards - the going has been tough.
Originally the "road to convergence" was to deliver final revenue standards by 4Q 2011. It's been delayed at least another 120 days after a recently revised exposure draft. However, the new standards are not expected to be effective until 2015, which begs the question of why we are focusing so much on it now.
With the significant changes the new rules will bring in revenue recognition, they will be retrospective up to three years prior, or 2013. If companies don't begin to analyze the rules soon, they might have to create two sets of records or completely restate financial statements, both of which are expensive and problematic.
How the new revenue recognition standards will affect private and public companies
For those who want a more detailed look at the proposed changes, we'll go into that later in this article. First, we wanted to give our view of how companies, employees and financial statement users will be affected in general. While many of the changes involve mainly language or minor tweaking, here are some significant differences in revenue recognition:
• Any contract tied to GAAP revenue will be impacted, such as earn outs on purchase agreements, compensation arrangements, buy/sell agreements and options awards.
• Net income can change, which could affect debt covenants. Some debt agreements are being drafted to require "good faith" renegotiation of covenants based on any new accounting standards.
• The new guidance may impact IT systems, requiring the collection of additional data for financial statement disclosures.
• Processes and controls may change to capture appropriate accounting data and estimates.
• It may impact how budgets are developed and updated.
• Changing revenue profiles will affect tax implications.
• Most importantly, gross margins will be affected depending on the industry. Any manufacturing, distribution or retail firm will likely see a difference on the top line margin. For example, financial analysis that focuses on gross margins will change with the new rules. Another example: Private company sellers could see lower gross margins, potentially affecting valuations.
Where we're at: A summary
The main principle of the new revenue recognition proposal is to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it expects to receive in exchange for those goods or services.
It sounds simple on the surface: Match revenues with the delivery of a good or service. But complicated situations, well, complicate things. A company would apply a five-step process to apply the revenue recognition proposals. They are:
Step 1: Identifying a contract - A contract is an agreement between two or more parties that creates enforceable rights and obligations. Contacts don't need to be written and if a party can terminate the contract before performance occurs, a contract does not exist.
Combining contracts - Contracts with the same customer entered into near or at the same time should be accounted for together if the following criteria are met: Contracts are negotiated as a package with a single commercial objective; the amount of consideration of one contract is impacted by the other; the goods and services are related in terms of design, technology or function.
Modifications, or change orders, are treated separately if the price of the good or service added is commensurate to it. If not, the contract modification is reallocated to existing performance obligations.
Step 2: Identifying performance obligations - A performance obligation is a promise in a contract to transfer a good or service to the customer. A company would account for a good or service separately only if it were "distinct," or if it could be sold separately with a distinct function and profit margin.
Step 3: Determining transaction price - The transaction price is the amount of consideration an entity expects to receive in exchange for transferring goods or services, excluding third party taxes and the like. The price should be estimated using the probability weighted amount or the most likely amount. This is one of the major changes from current U.S. GAAP. An allowance for expected credit losses should be estimated at the contract inception and presented as contra revenue on the top line instead of in G&A expense.
If the situation is unknown or uncertain and an entity is not able to reasonably ascertain whether it is entitled to receive an amount, revenue should not be recognized. Examples include when the entity has a lack of experience with specific types of contracts, or when the outcome is based on factors outside the control of the entity, or if the customer has an option to cancel the contract.
Step 4: Allocation of transaction price to performance obligations - The amount of revenue should be allocated to each separate performance obligation, based on relative selling prices on a stand-alone basis. The residual approach is also acceptable. This methodology is similar to recently enacted U.S. GAAP for most industries, but will be a major change for software companies, which are currently subject to much more restrictive requirements.
Step 5: Recognition of revenue on satisfaction of each performance obligation - Revenue is recognized when an entity has satisfied a performance obligation and the customer has control of the good or service. Control is defined as the customer having an unconditional obligation to pay, and having legal title and physical possession and risks and rewards of ownership.
For a performance obligation that is satisfied continuously, revenue should be recognized using a method of measuring progress towards completion. If progress can't be measured, revenue is not recognized. The methods of measuring progress may be an input method - based on the work towards performance - or output methods, which are based on performance to date. This methodology is not expected to be a significant change from the current percentage of completion accounting used for long-term contracts.
Warranties are troublesome in existing practice. The new guidance breaks warranties out into a separate performance contract if they are sold separately. For example, a retailer that sells an appliance with a separately priced warranty contract would recognize the revenue allocated to the appliance upon delivery, and the revenue allocated to the warranty contract over the warranty term. If the warranty is not sold separately, the revenue would be recognized upon delivery, with accrual of the estimated warranty costs.
Breakage revenue has become more important as gift cards and pre-purchased cell phone minutes have proliferated. Some companies, particularly private ones, recognize breakage revenue - unused minutes or gift card balances - up front based on established historical uses.
Under the new rules, when a pattern of breakage can be estimated, breakage revenue should be recognized on a proportionate basis, i.e. over the life of the gift card until expiration. If a pattern can't be estimated, such revenue should be recognized only when the customer's usage becomes remote, or past the expiration of the card, for example.
Contract costs. Costs of obtaining a contract are capitalized if they are incremental, directly related to a contract, and recoverable from the expected contract.
Uncertain consideration - This guidance covers things like sales-based royalties and performance bonuses. Currently, most companies do not recognize these contingent revenues until they are known, but under the new guidelines they will be recognized when reasonable assured, on a probability-weighted or most likely amount
Bill and hold transactions, where a customer prepays for goods that are delivered later are not currently discussed in GAAP, but are part of SEC guidance. The new guidance adopts the stringent SEC stance. Thus, some private companies will not recognize revenue as early as before. Up-front fees will be recognized over the estimated performance of the service, i.e. a health club membership, which, based on experience, could extend past the membership. Time value of money must be considered if there is a financing component to the sales, such as when there is more than a year between delivery of the good or service and customer payment.
Revenue recognition is one of the major projects on the proposed international convergence schedule. It was supposed to be completed by now but has been extended, in part because of the approximately 1,000 comments that have been written. Now, the new target for issuing a final standard is the end of 2012. As noted before, the mostly likely adoption would be in 2015, requiring either full or partial retrospective accounts going back up to three years.
About the author
James Brendel, CPA, CFE, is the national director of audit and accounting for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas and Southern California. He specializes in SEC reporting and assists companies with public offerings and complex accounting issues. Brendel can be reached at firstname.lastname@example.org or 303.298.9600.