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Revenue recognition: “Simplifying” a complex issue

February 20, 2012 Article 3 min read
Christa LaBrosse Jason Widman
Albert Einstein once challenged that “Everything should be made as simple as it is, but not simpler.” This is great advice for the accounting world, as efforts continue to converge U.S. GAAP (generally accepted accounting principles) with IFRS (International Financial Reporting Standards).

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As part of the convergence process, the accounting standard setters intend to use new guidance to account for—and simplify—revenue recognition, an area that standard setters have consistently acknowledged to be critical. Revenue is typically the single largest item reported within a company’s financial statements, and investors use associated trends and growth when assessing past performance and future potential. In addition to converging U.S. GAAP with IFRS rules, the changes are intended to streamline accounting for revenue across industries and correct inconsistencies in the numerous existing accounting standards. The process of implementing the “simplified” guidance will result in major challenges for many entities. 

Revenue recognition in the future

Revenue recognition is currently one of the most cumbersome areas of accounting. There are volumes of existing accounting guidance that address revenue recognition, including rules and interpretations specific to various industries. The accounting standard setters, the Financial Accounting Standards Board (FASB) for U.S. GAAP, and the International Accounting Standards Board (IASB) for IFRS, have issued the second draft of a joint proposal detailing how they believe revenue should be accounted for in the future. The FASB created five steps a company would follow under a unified contract-based approach to apply the new revenue recognition concepts:
  • Identify the contract(s) with the customer. 
  • Identify the separate performance obligations in the contract. 
  • Determine the transaction price. 
  • Allocate the transaction price.
  • Recognize revenue when a performance obligation is satisfied.
The proposed process would be applicable to all industries and would be applied to all contracts to provide goods or services to customers, except leases, insurance contracts, and financial instruments. The core principle of the proposed standard is that a company should recognize revenue when it transfers goods or services to a customer in the amount of consideration the company expects to receive from the customer.

The proposed model includes major changes from current practice, including:
  • Revenue would be recognized only from the transfer of goods or services to a customer. There is specific guidance for instances where control is transferred over time. This change will affect long-term contracts, such as construction contracts, as recognition of revenue prior to the completion of the contract would depend on the specific terms of the contract and who controls the work-in-progress as it’s being built or developed. 
  • For contracts with multiple performance obligations, such as software arrangements, a company would be required to account for all distinct goods or services, which could require it to separate a contract into different units of accounting from those identified in current practice. 
  • Collectability would affect how much revenue is recognized, rather than whether revenue is recognized. 
  • Greater use of estimates would be required in determining both the amount to allocate to a transaction and the basis for that allocation.
The proposed changes would also require companies to include more qualitative and quantitative information about contracts with customers in their financial statements. 

What should companies be doing now?

Implementation dates and timelines have not been determined or finalized. The proposed guidance is anticipated to be finalized in the first half of 2012. It’s expected that companies will not be required to begin using the new standard until 2015 or 2016. However, given the significant impact of the proposed changes to revenue recognition, companies should begin to assess the implications now. All existing contracts with customers will need to be analyzed and the accounting changed to conform to the new approach.

The following steps can be followed to determine the impact of the proposed changes:
  • Prepare an inventory of customer contracts and agreements. Be sure to include groups of smaller dollar contracts that could collectively be significant. 
  • For standard and customer specific contracts, review the contracts and agreements to summarize the key provisions, including:
    • Transaction price
    • Performance obligations
    • Payment provisions
    • Rights of return
    • Warranties
    • Calculate the estimated impact.
    • Prepare a pro forma balance sheet and income statement assuming the proposed guidance was effective. Share results with key stakeholders in the company. 
  • Identify compensation, loan, sales, and purchase agreements that have provisions based on earnings or other financial metrics that could be affected by the proposed guidance. Begin the process of renegotiating the terms of the arrangements to coincide with the implementation of the new guidance.

Begin now

Changes to accounting for revenue are approaching. While one of the goals of the standard setters is to simplify the guidance surrounding revenue recognition, the complexity of the rules that companies will be required to apply will not be diminished. Now is the time to begin preparations for the implementation of the changes. Companies that perform the appropriate assessments and are in advance of the implementation date will mitigate the challenges associated with the change.

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