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Revenue recognition: The hidden sixth step

March 24, 2016 Article 9 min read
David Grubb Christa LaBrosse
After the new revenue recognition standards areimplemented, will you still recognize your balancesheet? A hidden sixth step could affect key ratiosand measurements on contracts entered into beforethe effective date.

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Given that the FASB’s proposed new standard for revenue recognitionis focused on revenue, it’s no surprise that most of the discussion aboutthe proposal has focused on the income statement. That certainly is animportant part of the discussion, but it’s equally important to rememberthat any discussion of revenue recognition is also a discussion of revenuedeferral and, by extension, the capitalization of costs associated with thedeferred revenue. Closer examination of the new guidance reveals thatchanges in this area may have material effects on balance sheet accountsthat are used in measurements for everything from borrowing bases forlines of credit to commission payments to earnout agreements. Theguidance discusses a 5-step process to analyze each contract in orderto determine how your organization will recognize appropriate revenueunder the new rules. In fact, our analysis of the guidance suggests thata “hidden” sixth step will be needed in order to fully understand theimpact of the new standard on the balance sheet.

A quick review of the five steps

The new standard requires that performance obligations under each contract be identified in order to appropriately recognize revenue under the new guidance. The following 5-step review process should be performed on each individual customer contract: 

  1. Identify each contract the organization has with a customer
  2. Identify the specific performance obligations in each contract
  3. Determine the total transaction price for each contract
  4. Allocate the transaction price for each contract to each specific performance obligation under the contract
  5. Recognize the revenue allocated to each specific performance obligation as that obligation is satisfied

The "hidden" sixth step

The five steps focus on when you recognize revenue. The “hidden”sixth step examines the related costs that are deferred and carried onthe balance sheet.

  1. Analyze the balance sheet impact of contract costs and 6 contract assets and liabilities. 

In particular, the new standard provides guidance that may significantlychange the way your organization accounts for contract costs and themanner in which it presents contract-related assets and liabilities on thebalance sheet. 

Contract costs

Organizations often incur costs to obtain a contract that otherwise wouldnot have been incurred. They also incur costs to fulfill a contract before agood or service is provided to a customer. The revenue standard providesguidance on costs to obtain and fulfill a contract that should be recognizedas assets. Costs that are recognized as assets are amortized on a timelineconsistent with the transfer of the goods or services to which the assetsrelate, and are periodically reviewed for impairment.

Contract acquisition costs

These are the costs your organization incurs to obtain a contract with acustomer. Examples include selling and marketing, bid and proposal,sales commissions, and legal fees.

  • Only incremental costs (costs an organization would not haveincurred if the contract had not been obtained) are recognizedas assets under the new standard.
    Under the old guidance,organizations had an option to capitalize or not capitalize such costs.Many organizations expensed these types of costs as incurred. Under thenew guidance, organizations will be required to capitalize these costs.
    • Example: Sales commissions. If your organization is not awardedthe contract, you will not have to pay commissions. Organizationsthat do pay commissions when they win a contract must capture thesales commission costs associated with each contract and capitalizethem under the new guidance. The asset will be amortized over thelength of the contract with the customer. If organizations do notfollow the new guidance and continue to expense sales commissionsas incurred, assets on the balance sheet could be materiallyunderstated and expenses will be overstated.
  • Costs to obtain a contract that are not incremental will continueto be expensed as incurred.
    • Example: An A&E firm that engages specialists to help prepare thebid for a proposal. The money is spent on the proposal regardlessof whether or not the company is awarded the contract. Thesecosts would be expensed under both the old and new guidance,since the firm will have incurred this cost whether or not thecontract was obtained.
  • Organizations will need to consider all of the costs they incurwhen obtaining a contract and decide if they are incremental.
    We believe that sales commissions will be the most common typeof incremental cost capitalized under the new guidance.
  • Direct response advertising costs.
    If your organization uses directresponse advertising (such as mail-in coupons, business reply cards,or Internet hotspots), you should be aware that the new guidance supersedesand removes current FASB rules related to the treatment ofthese costs. Previously, companies could capitalize these costs if theymet certain criteria. The new rules require organizations to determineif money spent on direct response advertising is an incremental costattributable to a specific contract or if it is more accurately describedas a non-incremental cost of doing business or a cost that cannot beattributed to a particular contract. In most circumstances, we believethat advertising costs, including direct response advertising costs, arenot incremental and that organizations will be required to expensethem under the new guidance.

Contract fulfillment costs

These are the costs your organization incurs to fulfill its obligationsafter a contract is obtained. Examples include salaries and wages(direct labor costs) of employees who serve customers, directmaterials used in providing service to customers, and any costsexplicitly chargeable to a customer under the contract.

  • Management must determine whether the accounting forthese costs is addressed by other standards, for example, theguidance related to capitalization of inventory costs.
    Whereother standards exist, management should apply those standards.
  • Contract fulfillment costs not addressed by other standards arerequired to be capitalized if the following criteria are met:
    • The costs relate directly to a contract that the organization canspecifically identify
    • The costs generate or enhance resources of the organizationthat will be used in satisfying or continuing to satisfy futureperformance obligations
    • The costs are expected to be recovered
  • In most circumstances, under old rules, organizations wereable to choose whether or not to capitalize certain contractfulfillment costs.
    This option no longer exists.
    • Example: Set-up costs — Set-up costs are incurred at a contract’sinception. They allow an organization to fulfill its responsibilitiesunder the contract. They are common in software-related contractswhere data migration may need to occur prior to the startof a contract. Under the old guidance, no specific standardaddressed the capitalization of such costs. As a result, someentities chose to capitalize them while others expensed them.Under the new standard, these costs must be capitalized if theymeet the criteria and are amortized over the term of the contract.

Presentation of contract assets and liabilities

The presentation requirements under the new standard include asignificant change from current practice.

An organization will recognize an asset or liability if one of the partiesto the contract has performed before the other. For example, if theorganization performs its service in advance of receiving payment, itwill recognize a contract asset or receivable in its balance sheet. If theorganization receives payment before it performs its obligation underthe agreement, a contract liability is recognized. This is not significantlydifferent from current practice.

The bigger change is that the revenue standard makes a new distinctionbetween a contract asset and a receivable. The distinction is based onwhether receipt of the consideration is conditioned on something otherthan the passage of time.

  • A contract asset is an organization’s right to payment in exchangefor services or goods that it has transferred to a customer.
  • A receivable is a different kind of asset than a contract asset.
    A contract asset is reclassified as a receivable when an organization’sright to receive the consideration becomes unconditional (i.e., onlythe passage of time is required before payment is due).
    • Example: An organization enters a contract to deliver two productsto a customer. The products will be delivered at different times. Thecustomer is not required to pay for either product until 60 days afterboth products have been delivered.
    • Each product represents a separate performance obligation under thecontract and control transfers to the customer upon delivery.
    • When the first product is delivered, a contract asset should be createdand revenue should be recognized for the portion of the considerationallocated to the performance obligation for the first product.
    • When the second product is delivered, a receivable should be createdand revenue should be recognized for the portion of the considerationallocated to the performance obligation for the second product. Areceivable is recorded rather than a contract asset because the organization’sright to receive payment is based only on the passage oftime. Accordingly, the contract asset created when the first productwas delivered should be reclassified to a receivable upon delivery ofthe second product. Once the second product is delivered, the right ofthe organization to receive payment for the first product is no longerrestricted by anything other than the passage of time.

Considerations for executives

Currently, the new revenue standard is scheduled to apply to publicorganizations in annual reporting periods that begin after December 15,2017, and to nonpublic organizations in annual reporting periods thatbegin after December 15, 2018. While it’s never too early to start planningfor the change the new standard will have on your income statement, it’simportant to keep in mind that changes the new standard might make tobalance sheets in the future could have an impact on some contracts yourorganization is signing even now. Here are a few examples:

  • Lines of credit
    The borrowing base for some lines of credit arebased on amounts reported in balance sheet accounts, most commonlyaccounts receivable. As described above, balances in accounts receivablemay change as a result of the new standard. If your organizationhas a line of credit borrowing base related to accounts receivable, thenew standard could have an impact on the amount of short-term credityour organization has available.
  • Commission agreements
    If your organization relies on commissionagreements to compensate employees, the treatment of those costswill change under the new standard. Commissions that are directlyattributable to a specific contract will be treated as acquisition costsfor that contract and they will be capitalized and amortized over thelife of the contract. This treatment will shift the timing of thecompensation expense.
  • Earnout agreements
    Because the new standard will affectrevenue and change what costs are capitalized, thus affectingexpense recognition, earnout agreements that are expected tolast beyond the rule’s implementation date should take thechanges into account. Depending on the organization, reportedrevenue could increase or decrease significantly without anyactual change in the organization.

On top of these potentially unforeseen consequences, CEOs andCFOs also need to consider the systemic changes that will benecessary to track activities in order to report financial informationaccurately under the new standard. The clearest example of thischallenge is the new distinction between contract assets andreceivables. Accounting systems designed to meet currentstandards may not be equipped to measure the point at whicha payment no longer depends on anything but the passage oftime. The systemic problem may be solved in part by providersof accounting systems and software, but organizations will stillneed to develop processes to identify this point in the performanceof a contract.

If you have any questions about the new rules or if you needassistance with the implementation process, please contact yourPlante Moran engagement team or a member of our revenuerecognition implementation team.

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