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Wednesday, March 21, 2012

Revenue Recognition Overhaul Nears Final Phase


Companies will see significant changes in codes and disclosure rules

All authoritative guidance on revenue recognition is about to change, and the impact will be felt in every business category from software to construction to real estate franchisers. The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) are currently completing a joint project that will replace the huge body of existing revenue recognition standards with a new single model.

The sweeping move is designed to develop a standard that meets the needs of both U.S. and international constituents, and does so in a way that simplifies the guidelines and improves comparability across jurisdictions, entities and capital markets.

The boards began the project in 2008. The final draft will be issued sometime this year and become effective in 2015, creating a long, two-year runway for adoption that reflects the significance and magnitude of the change. However, the new rules will also be applied retrospectively, which means public companies will need to restate financials for 2013 and 2014.

Over the next two years the market will be given time to digest the new rules as SEC and National Accounting firm interpretations are developed along with the expected early adoption of a few large, foreign companies (allowed under the IASB’s version of the rule)  provides needed insight. This extended runway will be particularly important because the new guidance is essentially principles based and a departure from the prescriptive rules of the existing code.

Here’s a quick overview of the changes that are coming, following the five key steps to the revenue recognition process.

Step 1: Identify the contract with the customer. The first question is ‘Does your client’s contract fall within the scope of the new revenue recognition guidance?’ It may not. The new code has some specific exclusions for existing revenue principles under leases, insurance contracts, and other contractual rights and obligations that have specific revenue guidance such as financial instruments, debt, derivatives, and the transfer and servicing of assets.

Step 2: Identify the separate performance obligations in a contract. ‘Performance obligation’ refers to what is currently defined as a ‘deliverable’ under revenue guidance for multiple-element arrangements. The new language is meant to be more broadly encompassing as the IASB and FASB try to create a framework for companies to determine the distinct, unique deliverables in a contract.

The boards, however, did not draft the rule with the intent of significantly changing the way companies recognize separate deliverables or performance obligations. When you follow the new framework for multiple element arrangements, you will likely arrive at the same conclusions that you are at now.

Under the new rules you will first look at each of the distinct items and determine: Does the entity sell them separately and does each item provide a benefit to the customer on a standalone basis?

You must look at the nature of each item and then look closely at the entire arrangement to understand if it is being delivered as one item that is integrated and, therefore, in the eyes of the customer is a single solution or deliverable. If that is the case, then you step away from trying to recognize distinct elements.

Step 3: Determine the transaction price. In this step we are considering the estimated total amount of consideration to which the vendor expects to be entitled under the contract in exchange for transferring goods or services.

The new guidance will include the concept of ‘variable consideration.' For example, if you are developing software and you expect later to receive a performance bonus for completing it ahead of schedule, under the current rules you recognize the main price ratably and the bonus is deferred. But the new rules will allow for more judgment and flexibility in revenue recognition. Instead, you could use a probability weighted average or the most likely amount. So if you’re confident you are going to get the performance bonus, you could ratably recognize the performance bonus incrementally over the period that you are doing the work.

Companies who sell through distributors may see a significant change to their accounting as a result of the new concept of estimating consideration.They will be required to estimate returns and recognize all distributor sales on a sell-in basis, losing the ability to use the sales-out approach. 

The ‘time value of money’ is also a new concept in this standard. To illustrate this concept, if you are paid, for example, in years two and three of a contract, the new rules require you to take some of the revenue you would have recorded in year one and list it as interest expense and deferred revenue. This means that long-term contracts will be less profitable in early years because you are pushing a portion of the revenue attributable to those arrangements into the later years.

Also new is ‘collectability,’ or the gross amount you expect to earn. Historically companies have recorded bad debt as an SGA expense, but under the new rule, bad debt expense will be shown as a separate line item deduction in arriving at net revenue. Bad debt currently only impacts operating income, but in the future it will negatively impact gross profit/margin.

Step 4: Allocate the transaction price to the performance obligations. This is generally done on a relative selling-price approach, which is very similar to the new multiple-element revenue rules. The one distinction is that under the existing multiple element arrangements there is a hierarchy of evidence that you must look at in determining what is your best estimate of price: VSOE, third-party evidence, best estimate of selling price.

This new method, instead, jumps ahead to best estimate and says you should be looking at observable prices if they are available, and if they are not available, then use the estimation process.

Step 5: Recognize revenue when the performance obligation is satisfied. The current concept of ‘delivery criteria’ will also be replaced with ‘performance obligation.’

When a good or service is transferred to the control of a customer, that is when you should recognize revenue. The customer should be simultaneously receiving and assuming the benefits, and you should consider whether the customer has legal title, physical possession, and has the risks and rewards of ownership.

If you are recognizing revenue using the percentage of completion method, under the current rules it focuses on margin levelization, so that you are recognizing revenue in direct proportion to costs. Under the new rules, costs won’t necessarily be the right measure for percentage of completion. Instead you will be looking at the output and if that output is measurable. The result will be that gross margins will fluctuate more, and you will see more variability in your P&L.

Finally, the disclosure rules for the new guidance are onerous as compared to the existing rules. That’s because the new guidance is principles based and will require extensive interpretation. 

For example, one new requirement is to present a disaggregation of revenue, which means you will need to dissect your revenue into logical components, whether by geography, type of contract, or type of customer. You will have to report all of that revenue detail separately, and then you will need to provide a reconciliation using that same level of detail. That means that the deferred revenue on your balance sheet at the end of the year will need to be reconciled and rolled forward through the end of the current period for revenue that was recognized.

Another requirement will be to schedule out the satisfaction of performance obligations into future periods. Here, you will create a deferred revenue rollout and will have to schedule out deferred revenue and the roll off of that deferred revenue over the next five years by revenue type.

New  Software Meets the Demands of Revenue Recognition

Even with the introduction of so much technology into the accounting process, companies still struggle with the same issues in revenue recognition and other accounting operations that they have had for years.

It is a time consuming, overly manual and hard-to-manage process. The need for easy-to-access reports, with improvements in efficiency, accuracy and forecasting, is tremendous. The upcoming changes to the revenue recognition guidance from IASB and FASB will only increase the need to automate, improve accuracy and better ensure compliance.

“The key is to remove manual tasks and optimize your time,” said Yolande King, a manager in the consulting department of Armanino. “Companies want streamlined, automated processes that create fewer mistakes and changes, that make the sales close faster and reduce the potential for noncompliance or audit failure”

There are systems available now that address this wide range of needs and more — such as software from Intacct or Microsoft. It’s an impressive list of functionality, including:

    • Automating processes around software revenue deferrals
    • Creating revenue deferrals that happen at the time of posting
    • Supporting multi-entity & multi-currency functionality
    • Reporting capabilities such as future forecasting
    • Subscription and renewal management
    • Automatic VSOE allocation and reporting
    • Waterfall schedules for both revenue and deferred revenue

Functionalities also includes modification of schedules, including holds, edits, and changes, and much more. But a key before purchasing a system is to always perform your due diligence to ensure that the system can both adhere to the rules you must follow and can handle the transactions you need to manage.

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