A major change in how companies account for revenue from the contracts they write with their customers is lurking in the not-to-distant future. And the time to act is now.
The change has to do with how revenue from those contracts is “recognized” or reported on a company’s financial statements. For public companies using calendar year-end reporting, the new rules take effect January 1, 2018; for private companies, the implementation date is January 1, 2019.
But don’t shrug and turn the page just yet. There is a significant amount of work to be done ahead of time – impact assessment, re-characterizing revenue from multi-year contracts, and preparing your company’s systems and processes, for example. Assessing how the change may affect financial ratios viewed by banks and insurance companies will be especially important. Simply kicking the can down the road could make the adoption process more painful and costly as the deadline draws near.
Biggest Accounting Rule Change Since Sarbanes-Oxley
The new revenue recognition guidelines are known as ASC 606, Revenue from Contracts with Customers. Developed by the Financial Accounting Standards Board (FASB) after nearly ten years of input from the accounting and finance community, the new standard, issued in May, 2014, sets forth the how, when and how much revenue from contracts should be actually recorded as revenue.
The new standard eliminates the current transaction-specific rules of U.S. GAAP (generally accepted accounting principles) and replaces them with a principle-based approach more in keeping with the standard being used in most other countries. Soon, U.S. companies with contracts to provide goods or services to a customer will have to follow a five-step process to recognize the revenue they receive from those contracts:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to performance obligations
- Recognize revenue when (or as) the entity satisfies a performance obligation
The above references to “performance obligations” could be especially relevant to contractors, whose contracts for the construction of an asset (or a combination of assets) tend to span multiple years and may rely on both fixed-price and cost-plus elements.
Under the old U.S. GAAP rules, there were two allowed methods for recognizing how contractors satisfied their performance obligations; the “percentage of completion” method or the “completed contract” method (used when estimates about percentage of completion were not available). But once the new ASC 606 guidelines take effect, only the percentage of completion method will be allowed.
Here’s an example of how the change affects a contractor using the completed contracts method. A building that was constructed for disaster relief had a construction start date of November, 2016 and was completed in January 2017. Total project revenues were $700,000, although $300,000 of the total was earned prior to December 31, 2016.
Under the old completed contract method, no revenue from the project was reported in 2016; the full $700,000 was recognized in 2017. Under the new standard, $300,000 would be logged as 2016 revenue (to the extent of costs incurred and performance obligations satisfied) and $400,000 would be logged as 2017 revenue. It seems simple until you apply the change to earlier long-term contracts – the revenues from which must be re-characterized retrospectively – as well as adjust your contract-making practices going forward.
Rule Change May Reach into Other Business Areas
Now if you’re thinking that this type of change only affects your accounting and finance functions, think again. The new rules have the potential to impact areas of business operations across your entire organization – from sales operations to human resources, and from finance software tools to debt covenants.
For example, if you have employees who receive bonuses based on company revenues, how those bonuses are paid out and accounted for might be affected. If your sales contracts have been executed in a certain way over the years, the past accounting for the revenues derived from those contracts – and perhaps the contract terms going forward – may need to be adjusted. And of course, the technology systems that handle your company’s accounting and financial reporting – including process flows, data capture and calculations – will likely need updating to conform to the new guidelines.
Why is FASB doing this? The objective of ASC 606 is certainly laudable – to make the financial statements of tomorrow more transparent, so that readers (lenders, investors, etc.) can better understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.
But nearly every business will need to adjust their contract-writing and revenue-booking habits going forward. Contracts will have to be more detailed. Performance obligations will need to be agreed upon prior to the start of a job to determine how, when and how much revenue will be recorded as revenue. Work-in-process schedules will have to re-cast with performance obligations in mind. And financial statements will include a significant increase in disclosures.
As you can see, it’s high time for companies to start their engines, and rev up for the new revenue recognition standard. The finish line is closer than you think.