Revenue from contracts with customers: Significant new changes for manufacturers

On May 28, 2014, the Financial Accounting Standards Board (FASB) finalized a significant new accounting standard, Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, as subsequently amended, creating immense new changes regarding how companies will recognize and disclose their revenue from contracts with customers. The goal for this standard was primarily to align U.S. Generally Accepted Accounting Principles (GAAP) with International Financial Reporting Standards. The FASB also wanted to create “a more robust framework for addressing revenue issues,” which would replace the current industry-specific guidance. The core principle for the changes is to “recognize revenue in a way that communicates the transfer of goods or services to customers in an amount that reflects the consideration that you expect to be entitled to in exchange for those good or services.” This core principle is reflected in a new five-step framework used to determine when and how much revenue is to be recognized, as follows:

1. Identify the contract with the customer.
2. Identify the performance obligations.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.

Complying with the new standard will require significant changes to a manufacturing company’s internal controls over financial reporting, financial statements and disclosures, sales processes and procedures, sales contract provisions, and business practices. As the effective dates are quickly approaching for this new standard, companies should begin preparing for implementation now. Public companies are currently required to comply with the new standard, while nonpublic companies will be required to comply during the year ending December 31, 2019.

Pricing and discounts

Business strategies and practices should be implemented to increase the value of a company. Accounting standards should not solely drive such strategies, but consideration of such standards should be made so that decision-makers are aware of the impact. Therefore, here are some areas to be aware of under the new revenue standard that might impact sales pricing and discount strategies.

Variable consideration: The amount to be collected by customers is not always fixed due to discounts, return policies, price concessions, etc. For example, assume a company transacts with a customer to sell a product at a defined price, without any additional provisions, resulting in a fixed and known transaction price. This example results in known and fixed price consideration. In contrast, assume the company has consistently accepted payment from the customer at a price lower than the price stated in the contract or honors product returns, regardless of whether such returns are explicitly stated in the contract. In this case, certain variables (discounts or price concessions and returns) exist that would lead management to estimate the expected consideration that may differ from the fixed consideration, resulting in variable consideration.

This falls within the third step of the five-step framework (determining the transaction price). This process will become more cumbersome as management will need to rely heavily on good customer data to better estimate future customer payments, utilization of discounts, and any future product returns. Furthermore, if a manufacturing company is venturing into a new product line or geographic region, such judgments and estimates might be difficult to determine.

The new standard also requires management to assess whether it’s probable a significant revenue reversal may occur prior to recognizing revenue from a contract. If it’s deemed probable such circumstances will occur, any such significant revenue reversals should be estimated and constrained against variable consideration recognized.

The new standard also requires management to assess whether it’s probable a significant revenue reversal may occur prior to recognizing revenue from a contract.

In addition to estimating the expected consideration to be received under contracts, management will need to maintain good data to estimate product returns on sales. The new standard will require more emphasis on recognizing any estimated product returns and disclosure of those estimates. A new accounting entry will require companies to recognize an asset on the balance sheet for any estimated product returns which are still deemed salable.

Accounting processes may be altered to include the judgements of key management personnel in the initial steps of sales transaction cycles to better assess the inputs and variables that will be required to estimate variable consideration. This will also include the need to identify any potential significant revenue reversals, which requires an additional step of constraining revenue, as described above.

As mentioned, the new standard relies heavily on management to use good judgements in estimating the expected consideration that a company is entitled to. Such judgements and estimates are required to be disclosed in the notes to the financial statements, which could, unfortunately, highlight areas believed to be a company’s competitive advantage (pricing strategies and discounts, customer credit, price concessions offered to customer classes, payment terms, etc.).

Customer options for additional goods and services: Consider the situation in which a manufacturer provides volume discounts on product sales. The manufacturer may offer a customer a 10 percent prospective discount after the customer purchases 100,000 items. This example would generally result in a material right, which is treated as a separate performance obligation as it provides for a future discount for purchasing goods today. If, however, the arrangement includes future price reductions, without the reduction being conditional upon purchasing goods today, then it would typically be considered a marketing offer. Marketing offers are discounts granted in the normal course of business and, therefore, do not require special consideration under the new revenue standard.

However, if — based on preferred and strategic relationships — the manufacturer offers a deeper discount than normally provided, this is a material right. Material rights are required to be treated as separate performance obligations as in effect the customer is implicitly paying in advance for future goods. Management will be required to estimate whether the prospective discount will be utilized and effectively allocate the transaction price to the customer’s material right as well as the product sold under the contract (two performance obligations). The amount of the transaction price allocated to the material right will then be recognized as revenue once either the performance obligation has been satisfied or the discount expires.

If the above example were based on a retrospective volume rebate, meaning once 100,000 items were purchased, the discount was applied to purchases made up to that point, then management would then need to use its judgement to determine if it believed the customer would purchase the volume threshold and estimate the discount in its current recognition of revenue. Customer loyalty programs, such as those offered by food manufacturers and retailers, should also be considered as these might require significant accounting changes. To comply with this guideline, manufacturers should begin assessing their various discount programs.

Customer loyalty programs, such as those offered by food manufacturers and retailers, should also be considered as these might require significant accounting changes.

Products and services bundling

Product and services bundling that were previously an implicit part of an underlying sales contract may now be required to be carved out as separate performance obligations, significantly impacting the timing of when revenue is to be recognized.

Identifying performance obligations: Manufacturers that offer an installation service or bundled goods within customer contracts maybe required to recognize such services or goods as separate performance obligations. This will require management to “assess the goods or services promised in a contract to a customer and shall identify as a performance obligation each promise to transfer to the customer either a good or service that is distinct.”3 In this scenario, a company must allocate the contract transaction price and recognize revenue separately for all separate distinct promises, which could either delay or accelerate its current revenue recognition. For example, an accounting department may not be able to book the full amount of an invoice if the product has been shipped and received by the customer, but product installation has not yet occurred.

This guideline may be particularly challenging to implement because many companies have differing obligations bundled under one contract.

This guideline may be particularly challenging to implement because many companies have differing obligations bundled under one contract. Disentangling these will likely disrupt current internal control processes and procedures. Furthermore, it will require significant judgement to determine whether separate performance obligations exist under a contract. To exist, the promises must be separately identifiable and distinct from one another, which provides benefit to a customer either on its own or together with resources readily available to the customer. Such judgement is determined based on the customers’ perspective of the promises they perceive to be receiving under the contract.

Recognizing revenue over time

As manufacturers are selling produced goods, revenue is often recognized at a point in time. That point in time under the new standard is when the customer obtains control of the good. However, there are certain circumstances that will impact manufacturers recognizing revenue over time, as opposed to a point in time.

Specialized and customized products: With the new guidelines, manufacturers that produce highly customized products may be able to recognize revenue sooner. For example, a manufacturing company has entered into a contract with a customer to manufacture a specialized product, which could not be sold to other customers. This manufacturer may be able to recognize revenue as progress toward completion occurs. Under current guidance, this company wasn’t allowed to recognize revenue until the specialized product was complete and the risks and rewards of owning the product was transferred to the customer. The new standard requires revenue recognition to occur when control of a good transfers to a customer. For example, control passes over time as it relates to customized products when the product(s) has no alternative use and an enforceable right to payment for performance exists, as opposed to a point in time. This new method aligns better with the Uniform Commercial Code, which governs the legality of product sales via customer contracts.

Bill-and-hold arrangements: The new standard requires management consider recognizing warehousing as a separate performance obligation when the criteria for bill-and-hold arrangements are met. This implicit warehousing service would be recognized as revenue over time. This new treatment may actually delay current revenue recognition as under current guidance manufacturers that have met the criteria for bill-and-hold arrangements typically recognize the full contract price once the product is ready for customer pick up.

Services: As mentioned above, if a company offers services bundled within a customer contract for the sale of a good, it may be required to recognize such services as a separate performance obligation. Services are typically recognized over time, but not always, using a measure of progress that best depicts the transfer of control of the services to the customer.

Warranties and financing

Under the new standard, add-ons to contracts, such as warranties and long-term financing, will need to be assessed to determine if they meet the new requirements for service-type warranties and significant financing components.

Warranties: Most manufacturers offer warranties with their products. The new guidance differentiates between assurance-type warranties and service-type warranties. Assurance-type warranties essentially are warranties of merchantability — they promise that the good is free from manufacturing defect and will perform as intended. In contrast, a service-type warranty goes beyond ensuring that the good is free of manufacturing defect. This could take the form of providing maintenance services, repairs of customer inflicted damage, or “extended warranties.” The service-type warranty could result from a formal agreement or based on the company’s past practices of providing these free services in an effort to nurture and develop customer relationships.

Service-type warranties, under the new guidance, are to be treated as separate performance obligations requiring a contract’s transaction price to be allocated to them resulting in deferring revenue recognition and creating a contract liability. Management must use caution and judgement when estimating the allocation of a contract’s transaction price to such performance obligations. Oftentimes service-type warranties have separate contract terms represented by an “extended warranty” offer. Such separate contracts would require separate revenue recognition, consistent with current practice. The most significant change is that the new guidance doesn’t require warranties to be separately priced and written to be deemed service-type warranties. Rather, a company’s business practices in the type of service repairs actually performed in practice would also need to be considered.

Service-type warranties, under the new guidance, are to be treated as separate performance obligations.

Accounting departments will need to ensure they are communicating with customer service departments to properly understand the nature of the service repairs offered to customers under basic and extended warranties. If companies offer customers generous warranty service repairs, despite more limited contractual obligations, in an effort to build strong customer relationships and brand identity, they may be required to account for such warranties as separate performance obligations.

Significant financing: Manufacturers of large products, such as heavy equipment and machinery, may offer a significant financing component to customers. This is implicit within a contract if payment terms extend beyond one year from the date control of the product was transferred to the customer. Most often interest rates are contractually agreed upon and explicitly stated; however, they may not represent the market rate of interest for similar customers with comparable credit risk. Some companies may not change interest rates to reflect market and credit risk changes as it can be rather complex to do so. However, the new guidance suggests that appropriate interest rates be used to discount the present value of future payments for customers with similar credit risk, despite the contract’s explicitly stated interest rate. Companies should apply market rates as the implicit rate under such long-term arrangements. Consideration of materiality will be a factor in these situations as most rates will likely be materially accurate, not requiring the complexities of determining a more appropriate market rate of interest.

Contract costs

Incremental costs to obtain and fulfill contracts with customers are required to be capitalized under the new revenue standard. Current revenue standards allow companies to make an accounting policy election to capitalize such costs; however, many companies expense such costs as incurred in practice.

Costs to obtain contracts: Incremental costs of obtaining a contract with a customer, assuming the company expects to recover those costs, will now be required to be recognized as a contract asset. “The incremental costs of obtaining a contract are those costs that entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained”. The most common example of such costs are sales commissions paid for acquiring the customer contract.

How companies pay and offer sales commissions differ vastly; therefore, careful consideration and judgement will be required to determine only the incremental costs related to obtaining the contract and the related amount of the contract asset. For example, if a sales commission is paid in installments that are contingent on future events, then judgement will be required to determine whether such contingencies will be met. Other complex areas requiring judgement are commissions on contract renewals or modifications, commission payments that are subject to “clawback” or thresholds, the timing of when commissions are awarded, and whether commissions are based on a percentage of all future sales for a specific customer.

Careful consideration and judgement will be required to determine only the incremental costs related to obtaining the contract and the related amount of the contract asset.

These new contract assets will be required to be amortized, on a systematic basis, which best reflects the pattern of the transfer of goods and services of the underlying customer contract. As a practical expedient, these contract costs may be recognized as an expense when incurred if the amortization period of the asset is one year or less.

Costs to fulfill contracts: Costs incurred in fulfilling a contract with a customer will now be required to be recognized as a contract asset, unless such costs fall elsewhere in FASB’s Accounting Standards Codification. Such costs must relate directly to the contract and generate or enhance resources used to satisfy future performance obligations under the contract. Some examples might include costs that are explicitly chargeable to the customer under the contract or costs that are incurred only because of the contract, such as payments to subcontractors directly working on fulfilling the contract. These new contract assets will be required to be amortized on a systematic basis that best reflects the pattern of the transfer of goods and services of the underlying customer contract.

Customer control

Current revenue standards require that the risks and rewards of ownership be transferred to the customer under a sales transaction before revenue can be recognized. The new standard requires that the customer has obtained control of the product or benefit of service before revenue can be recognized.

Recognition upon control:Oftentimes manufacturers ship products under FOB shipping terms, covering damages in transit, known as synthetic FOB destination. As customer acceptance has not been achieved until delivery is complete, companies will recognize the full transaction as revenue once it has been delivered and accepted by the customer. If customer control is established upon delivery to the carrier, as may be the case under FOB shipping, then the new standard would consider the shipment as a separate service for protection against the risk of damage or loss, resulting in a separate performance obligation. Therefore, this may allow companies under such arrangements to recognize the portion of the consideration related to the product sale upon shipment and the remaining consideration related to shipping to be recognized upon delivery. In such cases, a practical expedient is available that will allow a company the option to treat shipping and handling as a fulfillment activity (not as a separate performance obligation) when shipment occurs subsequent to customer control of the product.

As this is one of the most significant areas of judgement in determining when to recognize revenue, it’s best practice to ensure companies have strong internal controls over financial reporting to support customers have obtained control of goods or services before recognizing revenue. As most manufacturers will recognize revenue at a point in time, special consideration should be made for sales near the end of reporting periods to ensure proper cut off of revenue recognition.

Adoption strategies: Modified retrospective method

To make the transition to the new standard easier, the FASB is allowing companies to use a modified retrospective method in the year of adoption. This allows companies to apply the new revenue standard only to the current-year financial statements. To use this method (for nonpublic companies), any contracts that are open or new will be subject to the new standard’s requirements as of January 1, 2019. Contracts that have been completed or are substantially complete at that date may be excluded. Those contracts that are partially, not substantially, complete will require a cumulative-effective adjustment to the opening balance of retained earnings on January 1, 2019. In addition, dual reporting will be required to account for revenue recognition under current GAAP standards to disclose to users the financial statement line item differences between the old and new GAAP revenue recognition standards.

Adoption and effective implementation will most likely be a significant and time-consuming process for most enterprises.

Adoption and effective implementation will most likely be a significant and time-consuming process for most enterprises. To keep implementation costs managed, align other dependent processes effectively, and reduce the likelihood of future errors and financial statement restatements related to revenue recognition, companies need to start planning for this change now, starting with the following actions:

• Properly identify contract terms and revenue streams.
• Identify areas requiring key estimates and judgments.
• Identify all performance obligations within contracts.
• Identify where variable consideration and constraints on revenue will be required.
• Identify the allocation of transaction prices to each performance obligation.
• Identify data that is not currently available impacting key estimates and judgments.
• Identify the nature of the service repairs provided to customers related to warranties.
• Identify shipping terms and when control is transferred to a customer (from the customer’s perspective).
• Identify processes and controls, technology enhancements and investments, and human resources needed, including capital and operating budgeting requirements.
• Begin researching and gathering more information about the new standard.

New disclosure requirements

The new revenue standard’s disclosure requirements are much more comprehensive and complex than the current standard’s requirements. The FASB’s objective in expanding disclosure requirements was to provide users more useful quantitative and qualitative information regarding revenue recognition. Current standards were vague, leading most companies to adopt boilerplate language to represent revenue recognition disclosures. While some companies might be privileged and only experience minor impacts in accounting for revenue under the new revenue standard, all will be impacted by the new disclosure requirements. The disclosure requirements outlined below are addressed to nonpublic companies as the FASB has granted nonpublic companies many practical expedients to avoid complex and costly disclosure requirements.

Disaggregation of revenue: Companies will be required to present or disclose separately revenue from its contracts with customers, revenue in accordance with Accounting Standards Codification Topic 606, and those revenue transactions accounted for in accordance with other accounting standards. The new standard “requires an entity to [also] disaggregate revenue from contracts with customers into categories that depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors.” Examples include major product lines, geographical regions, types of customer classes, types of contracts, contract duration (short-term and long-term contracts), timing of transfer of goods or services (point in time versus over time), and distribution channels.

Nonpublic companies are granted relief; they may elect not to apply this new quantitative disaggregation of revenue disclosure requirement.

Nonpublic companies are granted relief; they may elect not to apply this new quantitative disaggregation of revenue disclosure requirement. However, nonpublic companies will be required to disaggregate revenue according to the timing of revenue recognition (point in time versus over time).

Judgements and estimates:

More expanded qualitative information is again required when disclosing the following:

1. When performance obligations are typically satisfied
2. Significant payment terms
3. The nature of goods or services promised
4. Obligations for returns or refunds
5. Warranties

Other:

Additional disclosures will be required as follows:

1. Contract assets
2. Amount allocated to open performance obligations at year-end
3. Use of practical expedients
4. In year of adoption, financial statement line item impacts between current and new GAAP revenue recognition standards (assuming modified retrospective approach)

These new disclosures are requiring management to provide transparency in how performance obligations are determined and what promises are made to customers. The new revenue standard also requires disclosure of when performance obligations are typically satisfied (shipping terms, point in time versus over time, etc.). As described in Parts I and II, most of these areas will require significant management judgement as they might have an implicit nature to them, requiring consideration of business practices in conjunction with contractual terms. If variable consideration (Part I) is determined, how management identified, estimated, and allocated the consideration to its performance obligations, as well as changes in the transaction price, will need to be disclosed. If extended payment terms are offered, any significant financing components will be need to be disclosed. Expanded disclosures on returns or refund policies should be assessed for disclosure and whether any material rights are granted to customers. Furthermore, the nature of the service repairs offered under warranties and any estimated contract liabilities for warranties will need to be disclosed.

Obviously, these vast new disclosure requirements might trigger concerns with executive management as to what information is being shared with vendors and customers. Customers requesting financial statements may now gain insight into the different types of customer discounts offered to other customers (material rights versus marking offers addressed in Part I). Management should begin assessing these impacts now to best plan for how disclosures should be strategically presented while maintaining compliance requirements.

Management should begin assessing these impacts now to best plan for how disclosures should be strategically presented while maintaining compliance requirements.

The methodology and judgements used to determine estimates in all significant areas of recognizing revenue from contracts with customers will require disclosure. Judgements provided in disclosures will need to be supported by good historical data. To prepare for these new disclosure requirements, management should assess whether current IT systems are capable to support good estimates in these areas.

Conclusion

This new GAAP standard will likely require manufacturers to use more developed judgements and estimates in applying the five-step framework to customer sales, which ultimately drives when and how revenue will be recognized. The new standard will likely impact financial statements and disclosures, internal controls over financial reporting, sales processes and procedures, sales contract provisions, and business practices. Nonpublic companies should start assessing their current revenue streams and customer contracts and determine the reliability of customer data to ensure historical data can be used to develop new judgements and estimates.