Virtually every company that prepares GAAP-based financial statements will be affected by the Financial Accounting Standards Board’s (FASB’s) new revenue recognition standard. For private companies, the standard takes effect for annual reporting periods beginning after December 15, 2018, and for interim periods within annual reporting periods beginning after December 15, 2019.
Although private companies are expected to face challenges when adopting the revenue recognition standard, they enjoy an advantage – public companies were required to adopt the standard a year earlier. Therefore, private companies can learn from the experiences of their public peers and avoid surprises during the implementation phase.
A Summary Of The Revenue Recognition Standard
The new standard is found in Accounting Standards Codification (ASC) 606. It’s highly complex, but, in simple terms, ASC 606 establishes a new “core principle” for revenue recognition. The standard aims to “depict the transfer of 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 standard outlines this five-step process for determining when revenue should be recognized:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract, and
- Recognize revenue when (or as) the entity satisfies a performance obligation.
Annual Filings, An Important Source of Information
One good source of information about public companies’ experiences implementing the new revenue recognition standard is the annual reports they file with the SEC. Although the impact of the new standard will be different for each company, an informal review of Form 10-K filings indicates that, while some companies are changing the way they report revenue, many don’t expect the standard to have a material impact on their income statements.
However, there are drastic changes which need to be made to financial statement disclosures to ensure the requirements under the new standard are met.
Even companies whose net income won’t materially change are modifying their internal controls — or implementing new ones — to reflect the risks associated with revenue recognition under the new standard. These companies are moving towards this because the standard requires significant management judgment to identify separate performance obligations in a contract. Companies must:
- Evaluate all contracts with customers,
- Allocate the transaction price among those obligations,
- Determine when an obligation has been satisfied, and
- Estimate expected variable consideration to include in the transaction price.
Tighter internal controls may be needed to help ensure that these judgment calls are free from management bias or manipulation. In addition, many of these judgments will need to be disclosed in the footnotes that accompany an entity’s financial statements.
Challenges of Implementation
The accounting literature contains considerable anecdotal information about the challenges encountered by public companies in adopting the new standard. One common observation is that the time and effort executives invested in implementing the revenue recognition standard was far greater than they anticipated. For example, many companies underestimated what it would take to evaluate their contracts and to comply with the standard’s extensive disclosure requirements. They found that the information necessary for these disclosures was difficult to extract or unavailable and, in many cases, had to rely on estimates.
Executives were also surprised by the standard’s wide-reaching impact, including how it affected budgeting, tax planning, performance-based compensation arrangements, and IT systems.
As you prepare to implement ASC 606, you will want to make sure you understand how the standard is likely to impact your operations and try to anticipate potential hiccups. You will also want to ensure you have the resources you’ll need to adopt it in place, especially when it comes to having sufficient accounting expertise to manage the implementation process.
For assistance with revenue recognition standard implementation, contact your Untracht Early advisor.