Revenue recognition: What you do know could hurt you
Revenue recognition has been a hot topic since the Financial AccountingStandards Board (FASB) finalized a standard in May of 2014 that movesaway from a rules-based approach to a more principles-based model.The move erases decades of industry-specific guidance that, in manyinstances, spelled out in a relatively certain manner how an organizationshould recognize revenue from customers. That structure is beingreplaced with much broader guidelines that all entities should use todetermine how they recognize contract revenue from customers.
The original standard was scheduled to go into effect for nonpubliccompanies beginning with financial statements covering periods thatbegin after December 15, 2017. The FASB has deferred that effectivedate for one year, so the standard will be effective for nonpubliccompanies with financial statements that cover periods beginning afterDecember 15, 2018.
If your organization issues financial statements based on generallyaccepted accounting principles (GAAP) in the United States, the most important thing to understand about the new standards is that thetransition will involve significant planning, training, and process changes,regardless of the effective date. The one-year deferral gives you anopportunity to get started now and manage the transition on a reasonableschedule. Any delay on your part could cause significant difficulties as theeffective date approaches.
What you know can hurt you
As we have worked to gain an understanding of the new standard, we havenoticed an unusual conundrum. The new guidance is such a radical changefrom the previous revenue recognition process that one of the hardestparts about making the change is leaving behind any aspect of the analysisthat used to be performed under the old rules. This issue became apparentwhen some of our experienced professionals discussed the changes withentry-level staff who hadn’t worked with the old rules to any significantdegree. To fully understand the extent of the change, you must evaluateevery customer contract that your organization has from scratch withoutany 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 agreesto provide post-contract services (PCS) for a period of three years from thedate of software activation. These are distinct services being provided tothe customer. Neither the license nor the PCS is available on a standalonebasis, and there is no stated renewal fee for the PCS services.
The elements of the arrangement can be split into separate units of accountingif “vendor-specific objective evidence” (VSOE) of fair value exists.In the absence of VSOE, the elements of the arrangement would be treatedas a single unit of accounting.
VSOE typically exists when a product or service included in the contract issold separately. In our example, there is no VSOE since software and PCSare not sold separately. Accordingly, revenue is recognized on a straightline 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 separateperformance obligations under the contract and allocate the transactionprice to the performance obligations based on each component’s relativestandalone value. People who worked with the previous standard mightjump to the conclusion that a lack of VSOE results in an inability toseparate the elements of the contract into distinct units of accounting.The lack of a VSOE led some people we spoke with to assume that thecontract only had one performance obligation under the new principles.That assumption would lead to incorrect revenue recognition under thenew standard.
Correct treatment under the new standard
To recognize revenue correctly under the new guidance, you need toforget that the concept of VSOE ever existed. The new standard requiresthat each performance obligation under the contract be identified. Thesoftware license and PCS would be accounted for as separate performanceobligations, since they are distinct services under the contact. The softwarevendor would estimate the standalone selling prices of the software andPCS, since they are not sold separately. Revenue would be recognizedfor each performance obligation based on the estimated selling priceassigned to that performance obligation. Revenue allocated to the softwarewould be recognized upon delivery of the software. Revenue allocated tothe 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 reviewyour policies for revenue recognition with a clean slate. If you implementchanges 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 buthave not given it significant thought yet. In our discussions with theseentities, we frequently hear feedback that the organization has a standardcustomer contract and that it will be able to apply some uniform review to all and break out the performance obligations. In our experience, evenuniform contracts get modified regularly in order to address specific needsof individual customers. Entities that don’t take a careful look at eachcontract run the risk of generating significant concerns when their financialstatements are scrutinized by others, for example, by potential investors orduring a financial statement audit.
We recommend that you review each individual customer contract on itsown merits to determine how to appropriately recognize revenue underthe 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 eachspecific performance obligation under the contract.
- Recognize the revenue allocated to each specific performanceobligation as that obligation is satisfied.
A timeline for implementation
Even with FASB’s one-year deferral, most organizations we have talked toare still behind where they should be to implement this change smoothly.We recommend that organizations begin as quickly as possible to makesure that they allow time to effectively manage this significant change. Theimplementation 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!