Revenue Recognition: Ten Top Changes to Expect with the New Standard

Transcription

1 Revenue Recognition: Ten Top Changes to Expect with the New Standard /////////////////////////////////////////////////////////////////////////////// Lisa Starczewski Buchanan Ingersoll & Rooney

2 Revenue Recognition: Ten Top Changes to Expect with the New Standard Table of Contents: Introduction Ten Top Changes to Expect with the New Standard 1. Industry-specific guidance is out; thus, the new approach is more reliant on professional judgment and contract terms and conditions. 2. The new rules will apply to all entities that enter into contracts with customers. 3. The key to revenue recognition under the new approach is the transfer of control of a promised good or service (not the transfer of risks and rewards). 4. A single contract may contain a different number of separate performance obligations than under current U.S. GAAP. 5. Collectibility is no longer a recognition threshold and does not affect the measurement of transaction price. 6. The new guidance introduces a constraint on revenue that applies to variable consideration (rebates, refunds, credits and incentives). 7. The rules for accounting for long-term contracts are changing. 8. The rules for accounting for licenses are changing. 9. All reporting entities will allocate the transaction price to the good or service underlying each performance obligation on a relative stand-alone selling price basis. 10. For public entities applying U.S. GAAP, the new guidance will generally be effective for annual reporting periods beginning after December 15, 2016, including interim reporting periods therein. Early application is prohibited. Conclusion 2

3 Revenue Recognition: Ten Top Changes to Expect with the New Standard After three years, two exposure drafts, over 1,300 comment letters and countless meetings and outreach activities, the Financial Accounting Standards Board and International Accounting Standards Board (the Boards ) are within a few weeks of each issuing a new revenue standard. The main goals of the joint revenue recognition project are relatively straightforward convergence and consistency. There are currently significant differences between U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards with respect to revenue recognition principles and, as stated by Leslie Seidman, Chair of the FASB, It s important to have global comparability for the top line of every company in the world. Current U.S. GAAP, as codified in the Accounting Standards Codification (ASC) does not provide one, all-inclusive general standard on revenue recognition that applies across the board to all transactions and industries. Instead, ASC provides broad, conceptual guidelines and several other subtopics in the Codification provide additional guidance that applies, by its own terms, to specific types of transactions or industries. In some respects, therefore, the devil is currently in the details. The application of the industry-specific detailed guidance in current U.S. GAAP often results in companies accounting differently for transactions that are, in substance, economically similar. In addition, because the current international standards provide fewer specific requirements, companies applying IFRS often pick and choose specific U.S. GAAP guidance to fill in the holes. Both soon-to-be-released revenue standards will contain a new principled approach to revenue recognition that will apply to revenue from contracts with customers across all industries. The following is a list of ten important pieces of information relevant to the anticipated changes to the revenue recognition rules. Lisa Starczewski Buchanan Ingersoll & Rooney 3

4 1. Industry-specific guidance is out; thus, the new approach is more reliant on professional judgment and contract terms and conditions. The approach to revenue recognition is changing. Once the new guidance is effective, it will supersede the vast majority of the current industry-specific revenue recognition guidance. Thus, industryspecific guidance is out and a new, single comprehensive model with foundational principles and objectives is in. Under current U.S. GAAP, management and outside advisers are continually exercising judgment and analyzing contract terms in order to determine the proper way to account for transactions and events. However, in the context of revenue recognition, they are able to rely on a significant body of industryspecific guidance to aid in this determination. The elimination of this industry-specific guidance in favor of broad principles necessitates greater reliance on professional judgment, customary business practices and specific contract terms. Thus, lawyers and other advisers may play a key role in drafting contracts to clearly define when and how a reporting entity transfers value (control of goods or services) to a customer. The new guidance will also require an entity to use estimates more extensively than under current GAAP. 2. The new rules will apply to all entities that enter into contracts with customers. Unless a contract is specifically excepted from application of the revenue standard (e.g., insurance contracts and leases), the new guidance will apply. Thus, all entities will have to apply the new approach to revenue recognition and will be subject to expanded disclosure requirements. However, the new rules will impact certain industries more significantly than others, particularly those that presently rely on industry-specific guidance. The impact, though, will not always be a deferral in revenue recognition. In fact, in many cases, revenue recognition will be accelerated. 4

5 3. The key to revenue recognition under the new approach is the transfer of control of a promised good or service (not the transfer of risks and rewards). Under the new guidance, a reporting entity will recognize revenue when (or as) it satisfies a performance obligation, which is defined as the transfer of control of promised goods or services. A performance obligation may be satisfied at a point in time or over time. The new guidance will require a reporting entity to apply certain criteria to determine if a particular performance obligation is satisfied over time. If a performance obligation does not meet at least one of these criteria, the performance obligation will be considered satisfied at a point in time. In some cases, this new approach will affect long-standing patterns of revenue recognition. For example, under the new guidance, manufacturers of large volumes of homogeneous goods produced to a customer s specification may be required to recognize revenue as they produce the promised units (in contrast to when they deliver them) because the performance obligations are considered satisfied over time. 4. A single contract may contain a different number of separate performance obligations than under current U.S. GAAP. If a promised good or service is both capable of being distinct and distinct within the context of the contract, it will be considered a separate performance obligation under the new rules. A good or service is capable of being distinct if the customer is able to benefit from the good or service either on its own or together with other resources that are readily available to the customer. A good or service is distinct within the context of the contract if it is not highly dependent upon, or highly interrelated with, other promised goods or services in the contract (based on the application of a number of indicators). As an example, if a reporting entity provides a service as part of a warranty in addition to assurance that the product complies with agreed-upon specifications, the promised service may (depending upon application of the criteria) be considered a separate performance obligation. A performance 5

6 obligation may be explicitly stated in the contract or implied by an entity s customary business practices, published policies or specific statements. Thus, a reporting entity often will have to look beyond the terms of the contract to determine whether additional performance obligations exist. Under current GAAP, reasonable assurance of collectibility is one of the four fundamental revenue recognition criteria. In this context, collectibility refers to the customer s credit risk (i.e., the risk that the reporting entity will be unable to collect all or a portion of the contract consideration). Moreover, the new guidance eliminates the concept of vendor-specific objective evidence (VSOE) as a separation criterion. That is, under current U.S. GAAP, software vendors often treat all of the promised goods and services in a software arrangement as a single element (and recognize revenue once the last promised good or service is delivered) because they are unable to establish VSOE of fair value for one or more of the elements. Under the new rules, this inability to establish VSOE of fair value will not preclude an entity from identifying separate performance obligations in a software arrangement and allocating a portion of the transaction price to each obligation. 5. Collectibility is no longer a recognition threshold and does not affect the measurement of transaction price. Under the new guidance, assurance of collectibility will not be a recognition criterion and, for contracts without a significant financing component, transaction price will be equal to the amount of consideration to which the reporting entity is entitled not the amount that the reporting entity expects to receive. Transaction price will not be adjusted for customer credit risk, but rather, impairments of customer receivables will be separately presented as an expense. However, although collectibility will no longer be an explicit recognition criterion, it will still be an important concept in determining whether a contract exists and thus will still be a relevant concept under the new guidance. If collectibility is in doubt at a contract s inception, the reporting entity might conclude, depending on the level of doubt and other facts and circumstances, that the customer is not committed to 6

7 perform its obligation under the contract. In that case, there would be no contract to which the new revenue standard applies. 6. The new guidance introduces a constraint on revenue that applies to variable consideration (rebates, refunds, credits and incentives). Under current U.S. GAAP, one of the four revenue recognition criteria requires that consideration be fixed or determinable in order to be recognized. Thus, a reporting entity (with limited exceptions) does not include variable amounts in the transaction price until the variability is resolved. Under the new guidance, if the promised amount of consideration in the contract is variable, a reporting entity will estimate the total consideration to which it is entitled (using either the expected value approach or the most likely amount approach) and update that estimate at each reporting date. The reporting entity will apply a constraint, pursuant to which it will include variable consideration in transaction price if it has sufficient evidence or experience to support its conclusion that the revenue recognized should not be subject to significant revenue reversal. This assessment is qualitative and considers all of the facts and circumstances associated with both the risk of a revenue reversal arising from an uncertain future event and the magnitude of the reversal if that uncertain event were to occur. This is one of the many determinations under the new guidance that will require significant judgment. 7. The rules for accounting for longterm contracts are changing. In accounting for long-term contracts, under current U.S. GAAP, most entities recognize revenue by applying the percentage-ofcompletion method based on reliable estimates. Under the new rules, in a longterm contract, a performance obligation will be considered satisfied over time only if certain criteria are met and revenue will be recognized only when or as control of the asset is transferred to the customer. Thus, under the new approach, a reporting entity s accounting for a long-term construction or production contract will be dependent upon when and how control of the asset is transferred to the customer under the terms of the contract. 7

8 8. The rules for accounting for licenses are changing. The new guidance will provide one standard approach to accounting for licenses that applies to all industries. Some licenses will be accounted for as a promise to provide a right while others will be accounted for as a promise to provide access to property. The new guidance will likely accelerate revenue in cases in which a license is considered a promise to provide a right and is a separate performance obligation satisfied at a point in time. In addition, the pattern of revenue recognition may change significantly based on application of the new constraint on revenue and the fact the collectibility is no longer an explicit recognition threshold. Under the new approach, a licensor will recognize license revenue over time if (1) the license is a promise to provide a right or a promise to provide access but is not distinct and is, instead, bundled with services that are being performed over time; (2) the license is a promise to provide access; or (3) the constraint on revenue applies and requires the licensor to recognize all or a portion of the transaction price as the variability is resolved. 9. All reporting entities will allocate the transaction price to the good or service underlying each performance obligation on a relative stand-alone selling price basis. The stand-alone selling price is the price at which an entity would sell the good or service separately to a customer. The best evidence of that price is the observable price of a good or service when the entity sells that good or service separately to similar customers in similar circumstances. If the good or service is not sold separately (the stand-alone selling price is not directly observable), the reporting entity estimates its stand-alone selling price by considering market conditions, entity-specific factors and information about the customer or class of customer and by maximizing the use of observable inputs. The entity must consistently apply a suitable estimation method, such as the adjusted market assessment approach, the expected cost plus margin approach, and, under certain conditions, the residual approach. The general approach to determining relative stand-alone selling price in the new standard is similar to, although not identical 8

9 to, current U.S. GAAP. The most significant change is the fact that this approach applies across all industries, including the software industry. Software arrangements will be subject to the same rules as other contracts with customers. Thus, in the context of a software arrangement, the new rules eliminate the requirement that a software vendor allocate consideration based on VSOE of fair value. Under current U.S. GAAP, if a company does not have sufficient VSOE of fair value to allocate revenue to the various elements in a multiple-element software arrangement, the company must defer all revenue from the arrangement until the earlier of the date on which (1) the company has sufficient VSOE; or (2) the company has met the delivery requirement with respect to all elements in the arrangement. The new guidance will likely accelerate revenue in many cases because companies that now have to defer revenue (because there is no VSOE of fair value) will be able to recognize revenue earlier. 10. For public entities applying U.S. GAAP, the new guidance will generally be effective for annual reporting periods beginning after December 15, 2016, including interim reporting periods therein. Early application is prohibited. The IASB will require a public entity to apply the revenue standard for reporting periods beginning on or after January 1, 2017 and is allowing early application. With respect to transition, entities will have a choice to either (a) apply the new guidance retrospectively, with or without applying certain practical expedients; or (b) apply the new guidance pursuant to an alternative transition method (with no required restatement of comparative years). For nonpublic entities, the new rules will generally be effective for reporting periods beginning after December 15, 2017 and interim and annual reporting periods thereafter, although these entities may elect to apply the requirements a year earlier. 9

10 This list is by no means an exhaustive list of the anticipated changes to the revenue recognition rules. It is, instead, a summary of the most significant changes that can be used as starting point to understand the new approach and assess the impact of these changes. Companies should be assessing their current systems and processes to determine the changes that they will need to make in order to comply with the new approach. IT systems will have to be updated in order to properly capture revenue (in a systematic way) in the proper period. Companies must gain a detailed understanding of the new rules in order to analyze existing contracts and models and determine what changes will be applicable to them. Regulation S-X requires SEC registrants to disclose the effects of published but not yet adopted accounting standards. In order to avoid stating that they have not yet determined the effect of this very significant new revenue standard, companies will have to evaluate the new standard and disclose the possible effects of the new standard s approach to revenue recognition. Once the new rules are finalized, companies, when drafting new agreements, should consider the new approach and the impact it may have on specific types of transactions. Although the Boards plan to give companies significant lead time before requiring application of the final rules, the time to analyze and plan for their impact is now. Lisa Starczewski Buchanan Ingersoll & Rooney 10