Revenue recognition for commercial entities: Focus on the application
“We’re not as far along as we’d like to be.” That’s the prevailing sentiment from most of the organizations we’ve talked to about revenue recognition implementation.
Yet, when we look at the steps these companies have taken and the progress they’ve made, we’re often able to point out that they’re farther along than they think they are — and have successes and cautionary tales to share. Here are some frequently asked questions paired with best practices that can help others reduce trial and error and adopt the new revenue recognition guidance more efficiently.
1. How long did it take?
Many early adopters took longer to implement because they were feeling their way through the process with limited guidance. The shift from a predominantly rules-based set of standards with specific guidance for each industry to one principles-based standard designed to apply the revenue recognition model more consistently across all industries left a lot of questions open for interpretation.
Over time, more interpretative guidance has become available from FASB, the AICPA, and other sources. The time that early adopters spent navigating the process can now be significantly reduced by educating yourself and your team on the conclusions made by the standard-setters. The interpretative guidance is not authoritative, but it does offer a shortcut by providing the background for conclusions on a number of different topics in a variety of industries. Reading the interpretative guidance, understanding the fact patterns presented and how they are similar or different from your organization’s will reduce the time you spend interpreting the standard.
2. What did successful implementers do first?
They started by identifying the cross-functional team that would lead implementation at the organization and educating that team about the significance of the new revenue recognition process and the importance of getting the transition right. The most effective teams include members from accounting/finance, sales, and IT. If you plan to rely on outside advisors, line up those resources early in the process as well.
Next, they identified the C-level executives and audit committee members who would ultimately need to buy into the process, educated them, got them on board with the process, and kept them informed throughout. The tone at the top has a significant effect on the support the team gets from the rest of the organization. It’s not hyperbole to describe this as an “unprecedented” or “historic” change.
Finally, they built a timeline. It’s best to build your timeline by looking at your deadline for implementation and working backward. Don’t forget to allow the impact that revised revenue numbers might have on debt covenants or other agreements. If your agreements require certain metrics that will be affected by the change, you may need time to renegotiate those contracts to reflect the expected changes in the numbers under the new standard.
Many organizations don’t fully understand how many different departments manage revenue contracts and how different the terms of each contract can be.
3. What external resources did successful implementers use?
The information available to organizations adopting the new standard has increased significantly since the new rules were announced. Best sources now include:
- FASB Transition Resource Group papers
- Public filings of SEC registrants that have adopted early
- AICPA industry guidance
4. What departments were involved in implementation?
A cross-department and cross-functional team are needed to effectively implement the new standard. The obvious team members will come from the accounting, finance, and sales departments. However, most organizations also need to include individuals from operational departments, since they often had a hand in designing contracts and arrangements with customers. In addition, if your entity has a general counsel, having the legal department involved in the interpretation of contract terms can be useful.
Depending on the size of the organization, customer contracts may reside with the sales team — but beware the sales team that provides a “standard contract” for your review. Most organizations allow the sales staff some limited autonomy to modify standard provisions in order to reflect the needs of individual clients. It’s never safe to assume that all sales contracts are uniform copies of a standard agreement.
5. What financial statement line items were affected?
The new guidance can significantly affect the reported amounts of revenue at most organizations. However, the effects can reverberate throughout the financial statements and affect multiple other line items and disclosures. Don’t lose sight of some other areas that took organizations by surprise:
- Brokerage fees and commissions — likely to meet the criteria to be recognized as an asset and expensed over time under the new rules. While some organizations made a policy election for this accounting treatment under the old guidance, if it meets the criteria, capitalization is required under the new standard.
- Inventory — could be classified as a contract asset instead of inventory in instances where the revenue for the product meets the criteria to be recognized over time rather than when the product is shipped.
- Gift card liability — some retailers have identified that they can recognize breakage sooner, allowing for earlier recognition of revenue related to gift cards
These revelations came about after an “impact analysis” was performed, where the organizations walked through the revenue recognition model with their more significant revenue-producing contracts. In many instances, the organization’s conclusions after applying the new model were different from their expectations going into the exercise.
6. What were the biggest challenges in the implementation process?
The top three challenges that faced early adopters were:
- Getting started: The theory behind this new standard seems more daunting in the abstract than it really is. Once you start applying it to contracts, the new guidance will begin to become more familiar and intuitive.
- Creating an inventory of contracts: Many organizations don’t have a central repository that houses executed contracts. Additionally, many different departments manage revenue contracts, and the terms of each contract can be different. This tends to be an eye-opener for many teams working to implement the new standard.
- Understanding that this is a process change: Implementation will often result in a change to balance sheet and income statement amounts, but the key to effective implementation is building a process that can be repeated for all existing contracts as well as those to come in the future.
The process makes more sense when you start looking at the actual contracts that govern your relationships with your customers.
7. What were the most significant judgments you had to make at implementation?
The new standard moves from the former industry-specific rules-based approach to a much more subjective principles-based model. There are significant judgments in every step of the model, such as:
- What constitutes a contract?
- What constitutes a distinct performance obligation?
- What effect does variable consideration have on the recognition of revenue?
- What is the best measure of the standalone selling price for each performance obligation?
- What are the most relevant indicators of transfer of control?
- How relevant are shipping terms in determining transfer of control?
8. What three things would you recommend organizations keep in mind about implementation?
- Start early. Don’t underestimate the process, but also don’t let the process overwhelm you.
- Be realistic about time commitments and resource allocations.
- Avoid the mindset that nothing will change. This process is definitely not about committing to a revenue number and working backward. Commit to an implementation plan, but be aware that even that is likely to change as you get into the process.
Of all the advice we can share, perhaps the most important is to get past the theory of this new standard and get started on the application of it as quickly as possible. The process makes a lot more sense when you start looking at actual contracts. As always, if you run into challenges, we’re here to help.