The top line of your company’s income statement is revenue. So, it tends to receive a lot of attention from investors, lenders and other stakeholders. Why? It’s a telltale sign whether your company is growing or declining based on changes in revenue. Moreover, changes in the composition of revenue can provide insight into your strategic plans.
Starting in 2018, if your company enters into contracts, it may need to update the way revenue is reported under new accounting guidance that goes into effect for public companies. Private companies get an extra year to change their reporting practices and systems to comply with this new standard.
Here are the details on what’s changing, including expanded disclosure requirements that will affect a wide range of businesses.
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, will result in a major shift in the way some companies report revenue. Little change is expected for simple point-of-sale retail transactions; revenue will continue to be recognized when goods or services are delivered to the customer. For long-duration, multi-element contracts, sales that include incentives for customers with poor credit, and contracts with built-in discounts or performance bonuses, the process gets more complicated.
The breadth of change under the new standard depends on your industry. Companies that currently follow industry-specific revenue recognition rules under U.S. Generally Accepted Accounting Principles (GAAP) will feel the biggest effects from these changes. Examples include telecommunications companies, software manufacturers, airlines, defense contractors, hospitality, gaming companies, and health care providers. Nearly all companies will be affected by the expanded disclosure requirements, which call for more details on the composition of revenues.
Exceptions to the new rules include leases, insurance contracts, financial instruments, guarantees and nonmonetary exchanges between entities in the same line of business to facilitate sales. These transactions remain within the scope of existing industry-specific GAAP.
5 Steps For Recognizing Revenue
The updated guidance requires management to make more judgment calls based on overriding principles compared to current practice. The new standard calls for five steps to decide how and when to recognize revenue:
- Identify a contract with a customer.
- Separate the contract’s “performance obligations” (discrete promises to transfer goods or services).
- Determine the transaction price.
- Allocate the transaction price to each performance obligation.
- Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.
The updated standard essentially requires companies to assign a transaction price to each of a contract’s separate performance obligations and consider whether it’s “probable” they won’t have to make a significant reversal of revenue in the future. Transaction prices may also need to be adjusted to reflect the time value of money. Different companies may interpret the “probable” threshold differently, however, threatening financial statement comparability among entities.
It’s important to note that the new standard doesn’t change the total amount of revenue your company reports. Rather it’s a matter of timing. Under the new standard, companies may report revenue sooner or later, depending on the terms of their contracts and management’s application of the “probable” threshold.
Use of Estimates
Recognizing revenue under the new standard will require management to make subjective judgment calls on such issues as:
- Identifying performance obligations,
- Estimating standalone transaction prices for distinct goods and services, and
- Evaluating variable consideration (such as rebates, discounts, bonuses and rights to return) when determining the transaction price.
It’s important to assess whether the use of estimates could expose your company to additional financial reporting risks as the start date approaches. The Securities and Exchange Commission’s Office of the Chief Accountant is urging public companies to conduct a risk assessment to ensure that they meet their financial reporting responsibilities under the new standard. The implementation process may include adopting new internal controls to help prevent management bias and inadvertent errors that could mislead stakeholders about contract revenue.
Expect more questions from your accountant regarding revenue in light of the increased risk of potential misstatements. Also, expect your auditor to request more documentation and perform different auditing procedures than in previous years if your statements are audited. Understand that the new rule may result in temporary book-to-tax reporting differences, and that’s because the tax rules regarding revenue recognition haven’t yet changed to jive with the new accounting standard.
You should have already started the process for adopting the new revenue recognition standard if your Maine business issues comparative financial statements under GAAP. Most public companies that have already made the changes report that it takes more time and effort than they initially expected.
Contact Filler & Associates in Portland, ME, or your accounting professional, to determine the extent to which the guidance will affect your company and how to revise your recordkeeping procedures, accounting systems and internal controls to facilitate compliance.