Your Revenue Recognition may not be Recognizable Soon!

March 03, 2014 By Kent Thomas

If you are a “finance geek”, this will not be news to you, however, if your world does not revolve around financial and accounting reporting standards, this may come as quite a surprise. The entities responsible for setting U.S. Generally Accepted Accounting Standards (GAAP) and International Financial Reporting Standards (IFRS) are close (expected sometime in Q1 of this year) to issuing a new, common standard for world-wide revenue recognition that will change that way most businesses think about how their revenue is recognized. Even if your business is not audited, in order to produce financial statements that comply with GAAP, you will have to adopt this new standard! Here is a brief summary of some of the changes most likely to affect small businesses:

  1. Does a contract exist? If no contract exists, then revenue from such an arrangement either cannot be recognized or must be delayed until proof of a contractual arrangement is demonstrated. In the past, companies following US GAAP could evaluate a contractual arrangement based on the “persuasive evidence of arrangement” criteria. This change will cause some businesses to re-think their accounting policies as the following requirements to determine if a contract exists become effective:
    1. Commercial substance – meaning changes in cash flows would be expected as a result of the arrangement.
    2. Approval and commitment to perform obligations from both parties.
    3. Identification of rights, responsibilities and payment terms by both parties
  2. A new framework for reporting on contract modifications will be included in the new standard that may be a big deal for if you plan to adopt the new standard retrospectively. You will need to consider past contract modifications in determining current contract balances and future revenue recognition therefrom. Think about a 10 or 20-year contracts with multiple contract modifications!
  3. Identifying different performance obligations – If you have followed long-term contract accounting under AICPA Statement of Position 81-1, you typically think of the contract as the unit of account but the new guidance may cause you to find components of a contract that you will identify separately and think about differently, perhaps with a new recognition pattern for those components. An example of this might be separating a software license from the upgrades or maintenance component.
  4. Judgment in selling price estimates – A lot of judgment will be involved in the estimation of the selling price. It will be important for management to establish and maintain sound policies. Documenting the judgments also will be important to build out an infrastructure to support the estimates. Identifying key credits such as rebates, price protections, and returns—and booking the reserves for them—will be important, also.
  5. New depiction of transfer over time – Many companies use percentage of completion in a “units-of-delivery” method under U.S. GAAP to depict transfer of goods or services over time to a customer. Under the new guidance, shifting to a “cost-to-cost” approach may provide more accurate depiction of the transfer of goods over time. The cost-to-cost method presents the ratio of costs already incurred compared to the expected total cost of completing a project. But that might lead to operational challenges as revenue recognition changes – including performance incentives that no longer drive the desired behavior. Some companies understandably like to use output measures because you can objectively identify them, and they drive the right operational behavior (i.e., you get the unit done and out the door, and that’s your milestone.) The new standard may create challenges for some companies in this area.

In addition to these changes to the revenue recognition process, there are significant changes to the disclosures required under the new standard. All of this means that you “have to know what you don’t know” and either get educated or get the help necessary to make sure that you are able to follow the new standard.

If this is all “news” to you, talk to your CFO, Controller or financial advisor. Even though it appears that the new standard won’t be effective until 2017, this is not something that you can wait until 2016 to start thinking about. In most cases you will need to change procedures and accounting policies well in advance so that you can capture the information necessary to make the proper determinations. In some cases, you may have to plan on selecting and implementing a new software / ERP system. So, it’s time to start evaluating how this applies to and will affect your business now and in the future. Advanced CFO Solutions’ consultants are ready to help you through this process and will make it as painless as possible – give us a call and let us be your revenue recognition solution!

Kent Thomas is the Founding Partner of Advanced CFO. In that role he has served as the outsourced CFO of over 75 different businesses.  Kent is a licensed CPA and recently served as the President of the Utah Association of CPA’s. He was a founding member of the Olympus Angel Investors and is active in the Utah entrepreneurial community where he advises companies, associations, and educational institutions and is a frequent speaker on finance, accounting and entrepreneurship. Kent is married to Kim Ericson – between them they have eight children and eight grandchildren. They enjoy running, hiking, water sports (especially Lake Powell) and international travel.

 

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