Revenue recognition: What you do know could hurt you
Revenue recognition has been a hot topic since the Financial Accounting Standards Board (FASB) finalized a standard in May of 2014 that moves away from a rules-based approach to a more principles-based model. The move erases decades of industry-specific guidance that, in many instances, spelled out in a relatively certain manner how an organization should recognize revenue from customers. That structure is being replaced with much broader guidelines that all entities should use to determine how they recognize contract revenue from customers.
The original standard was scheduled to go into effect for nonpublic companies beginning with financial statements covering periods that begin after December 15, 2017. The FASB has deferred that effective date for one year, so the standard will be effective for nonpublic companies with financial statements that cover periods beginning after December 15, 2018.
If your organization issues financial statements based on generally accepted accounting principles (GAAP) in the United States, the most important thing to understand about the new standards is that the transition will involve significant planning, training, and process changes, regardless of the effective date. The one-year deferral gives you an opportunity to get started now and manage the transition on a reasonable schedule. Any delay on your part could cause significant difficulties as the effective date approaches.
What you know can hurt you
As we have worked to gain an understanding of the new standard, we have noticed an unusual conundrum. The new guidance is such a radical change from the previous revenue recognition process that one of the hardest parts about making the change is leaving behind any aspect of the analysis that used to be performed under the old rules. This issue became apparent when some of our experienced professionals discussed the changes with entry-level staff who hadn’t worked with the old rules to any significant degree. To fully understand the extent of the change, you must evaluate every customer contract that your organization has from scratch without any thought of how revenue has been recognized under the old standard. An example might help you understand.
A software vendor sells a customer a perpetual software license and agrees to provide post-contract services (PCS) for a period of three years from the date of software activation. These are distinct services being provided to the customer. Neither the license nor the PCS is available on a standalone basis, and there is no stated renewal fee for the PCS services.
The elements of the arrangement can be split into separate units of accounting if “vendor-specific objective evidence” (VSOE) of fair value exists. In the absence of VSOE, the elements of the arrangement would be treated as a single unit of accounting.
VSOE typically exists when a product or service included in the contract is sold separately. In our example, there is no VSOE since software and PCS are not sold separately. Accordingly, revenue is recognized on a straight line basis over the duration of the contract.
Incorrect treatment applying new principles with old concepts in mind
The new guidance requires the organization to identify the separate performance obligations under the contract and allocate the transaction price to the performance obligations based on each component’s relative standalone value. People who worked with the previous standard might jump to the conclusion that a lack of VSOE results in an inability to separate the elements of the contract into distinct units of accounting. The lack of a VSOE led some people we spoke with to assume that the contract only had one performance obligation under the new principles. That assumption would lead to incorrect revenue recognition under the new standard.
Correct treatment under the new standard
To recognize revenue correctly under the new guidance, you need to forget that the concept of VSOE ever existed. The new standard requires that each performance obligation under the contract be identified. The software license and PCS would be accounted for as separate performance obligations, since they are distinct services under the contact. The software vendor would estimate the standalone selling prices of the software and PCS, since they are not sold separately. Revenue would be recognized for each performance obligation based on the estimated selling price assigned to that performance obligation. Revenue allocated to the software would be recognized upon delivery of the software. Revenue allocated to the PCS would be recognized over the duration of the contract.
This example is obviously specific to the software industry. However, there are situations like this in every industry. It’s important that you review your policies for revenue recognition with a clean slate. If you implement changes based on a view of the new principles as a tweak to the old rules, you run the significant risk of recognizing revenue incorrectly.
Five steps for every contract
Many organizations have taken a cursory glance at the new standard but have not given it significant thought yet. In our discussions with these entities, we frequently hear feedback that the organization has a standard customer contract and that it will be able to apply some uniform review to all and break out the performance obligations. In our experience, even uniform contracts get modified regularly in order to address specific needs of individual customers. Entities that don’t take a careful look at each contract run the risk of generating significant concerns when their financial statements are scrutinized by others, for example, by potential investors or during a financial statement audit.
We recommend that you review each individual customer contract on its own merits to determine how to appropriately recognize revenue under the new standard. The analysis is a five-step process:
- Identify each contract the organization has with a customer.
- Identify the specific performance obligations in each contract.
- Determine the total transaction price for each contract.
- Allocate the transaction price for each contract to each specific performance obligation under the contract.
- Recognize the revenue allocated to each specific performance obligation as that obligation is satisfied.
A timeline for implementation
Even with FASB’s one-year deferral, most organizations we have talked to are still behind where they should be to implement this change smoothly. We recommend that organizations begin as quickly as possible to make sure that they allow time to effectively manage this significant change. The implementation can be broken down into the following phases:
- 2015 to 2016:
- Identify project leaders and sponsors.
- Assemble an internal task force.
- Train and educate relevant personnel.
- Inventory contracts and terms.
- Begin to apply standard to a sample of the organization’s contracts.
- Impact analysis
- Implementation, which may include running parallel systems for a period of time.
- Go live!