On May 28, 2014, the Financial Accounting Standards
Board (FASB) finalized a significant new accounting
standard, Accounting Standards Update (ASU) No.
2014-09, Revenue from Contracts with Customers, as
subsequently amended, creating immense new changes
regarding how companies will recognize and disclose
their revenue from contracts with customers. The goal
for this standard was primarily to align U.S. Generally
Accepted Accounting Principles (GAAP) with International
Financial Reporting Standards. The FASB also wanted to
create “a more robust framework for addressing revenue
issues,”1 which would replace the current industry-
specific guidance. The core principle for the changes is
to “recognize revenue in a way that communicates the
transfer of goods or services to customers in an amount
that reflects the consideration that you expect to be
entitled to in exchange for those good or services.”2 This
core principle is reflected in a new five-step framework
used to determine when and how much revenue is to be
recognized, as follows (note that these steps might not
always be assessed in this order):
Complying with the new standard will likely require
significant changes to a manufacturing company’s
internal controls over financial reporting, financial
statements and disclosures, sales processes and
procedures, sales contract provisions, and business
practices. As the effective dates are quickly approaching
for this new standard, companies should begin preparing
for implementation now. Public companies will be
required to comply with the new standard for the year
ending December 31, 2018, while nonpublic companies
are provided an additional year requiring compliance
during the year ending December 31, 2019. This three-
part guide highlights certain areas likely to impact
nonpublic manufacturing companies and provides
some recommendations to help prepare companies for
compliance. This is not all encompassing and is only the
“tip of the iceberg” on areas addressed.
Below we introduce areas of impact in pricing and
discounts, product and service bundling, and recognizing
revenue over time. In Part II, we address changes in
warranties, contract costs, and customer control as
well as adoption requirements. In Part III, we cover new
disclosure requirements.
PRICING AND DISCOUNTS
Business strategies and practices should be implemented
to increase the value of a company. Accounting
standards should not solely drive such strategies, but
consideration of such standards should be made.
Therefore, here are some areas to be aware of under the
new revenue standard that might impact sales pricing
and discount strategies.
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Revenue from Contracts with Customers:
Significant New Changes for Manufacturers
WHITE PAPER
By Ben Milius and Kreg Brown
1. Identify the contract with the customer.
2. Identify the performance obligations.
3. Determine the transaction price.
4. Allocate the transaction price to the
performance obligations.
5. Recognize revenue when (or as) the entity
satisfies a performance obligation.
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2 ASU No. 2014-09
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Variable consideration: The new standard requires
management to use judgements and estimates in
determining the amount customers will pay for customer
sales. The amount to be collected by customers is not
always fixed due to discounts, return policies, price
concessions, etc. For example, assume a company
transacts with a customer to sell a product at a defined
price, without any additional provisions, resulting in
a fixed and known transaction price. Obviously, this
example results in known and fixed price consideration.
In contrast, assume the company has consistently
accepted payment from the customer at a price
lower than the price stated in the contract or honors
product returns, regardless of whether such returns
are explicitly stated in the contract. In this case, certain
variables (discounts or price concessions and returns)
exist that would lead management to estimate the
expected consideration that may differ from the fixed
consideration, resulting in variable consideration.
This falls within the third step of the five-step framework
(determining the transaction price). This process will
become more cumbersome as management will need
to rely heavily on good customer data to better estimate
future customer payments, utilization of discounts,
and any future product returns. Furthermore, if a
manufacturing company is venturing into a new product
line or geographic region, such judgments and estimates
might be difficult to determine.
The new standard also requires management to assess
whether it is probable a significant revenue reversal
may occur prior to recognizing revenue from a contract.
If it is deemed probable such circumstances will occur,
any such significant revenue reversals should be
estimated and constrained against variable consideration
recognized. This will likely require management to better
assess customer credit risk.
In addition to estimating the expected consideration
to be received under contracts, management will need
to maintain good data to estimate product returns on
sales. The new standard will require more emphasis
on recognizing any estimated product returns and
disclosure of those estimates. A new accounting entry
will require companies to recognize an asset on the
balance sheet for any estimated product returns.
Accounting processes will likely be altered to include
the judgements of key management personnel in the
initial steps of sales transaction cycles to better assess
the inputs and variables that will be required to estimate
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variable consideration. This will also include the need
to identify any potential significant revenue reversals,
which requires an additional step of constraining
revenue, as described above. Processes may also
require improvement to current customer credit risk
assessments to better identify between price concessions
and bad credit in the case customers do not pay full fixed
contract prices.
As mentioned, the new standard relies heavily on
management to use good judgements in estimating
the expected consideration that will be collected. Such
judgements and estimates are required to be disclosed
in the notes to the financial statements, which could,
unfortunately, highlight areas believed to be a company’s
competitive advantage (pricing strategies and discounts,
customer credit, price concessions offered to customer
classes, payment terms, etc.).
Customer options for additional goods and services:
Consider the situation in which a manufacturer provides
volume discounts on product sales. The manufacturer
may offer a customer a 10% prospective discount for
purchasing more than 100,000 items. If the manufacturer
typically provides this discount to similar customer
classes in similar geographical areas or markets, it’s
considered a marketing offer. Marketing offers are
discounts granted in the normal course of business and,
therefore, do not require special consideration under the
new revenue standard.
However, if — based on preferred and strategic
relationships — the manufacturer offers a deeper
discount than normally provided, this is a material
right. Material rights are required to be treated as
separate performance obligations as in effect the
customer is implicitly paying in advance for future goods.
Management will be required to estimate whether the
prospective discount will be utilized and effectively
allocate the transaction price to the customer’s material
right as well as the product sold under the contract
(two performance obligations). The amount of the
transaction price allocated to the material right will then
be recognized as revenue once either the performance
obligation has been satisfied or the discount expires.
If the above example were based on a retrospective
volume rebate, meaning once 100,000 items were
purchased the discount was applied to purchases made
up to that point, then management would need to use
its judgement to determine if it believed the customer
would purchase the volume threshold and estimate the
discount in its current recognition of revenue. Customer
loyalty programs, such as those offered by food
manufacturers and retailers, should also be considered
as these might require significant accounting changes. To
comply with this guideline, manufacturers should begin
assessing their various discount programs.
PRODUCTS AND SERVICES BUNDLING
Product and services bundling that were previously an
implicit part of an underlying sales contract may now
be required to be carved out as separate performance
obligations, significantly impacting the timing of when
revenue is to be recognized.
Identifying performance obligations: Manufacturers
that offer an installation service or bundled goods within
customer contracts will likely be required to recognize
such services or goods as separate performance
obligations. This will require management to “assess the
goods or services promised in a contract to a customer
and shall identify as a performance obligation each
promise to transfer to the customer either a good or
service that is distinct.”3 In this scenario, a company must
allocate the contract transaction price and recognize
revenue separately for all separate promises, which
could either delay or accelerate its current revenue
recognition. For example, an accounting department may
not be able to book the full amount of an invoice if the
product has been shipped and received by the customer,
but product installation has not yet occurred.
This guideline may be particularly challenging to
implement because many companies have differing
obligations bundled under one contract. Disentangling
these will likely disrupt current internal control processes
and procedures. Furthermore, it will require significant
judgement to determine whether separate performance
obligations exist under a contract. To exist, the promises
must be separately identifiable and distinct from one
another, which provides benefit to a customer either
on its own or together with resources readily available
to the customer. It is recommended such judgement is
determined based on the customers’ perspective of the
promises they perceive to be receiving under the contract.
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RECOGNIZING REVENUE OVER TIME
As manufacturers are selling produced goods, revenue
is typically recognized at a point in time. That point in
time under the new standard is when the customer
obtains control of the good. However, there are certain
circumstances that will impact manufacturers recognizing
revenue over time, as opposed to a point in time.
Specialized and customized products: With the new
guidelines, manufacturers that produce highly customized
products will likely be able to recognize revenue sooner.
For example, a manufacturing company has entered into
a contract with a customer to manufacture a specialized
product, which could not be sold to other customers. This
manufacturer will likely be able to recognize revenue
as progress toward completion occurs. Under current
guidance, this company was not allowed to recognize
revenue until the specialized product was complete
and the risks and rewards of owning the product was
transferred to the customer. The new standard requires
that customized product has no alternative use and that
an enforceable right to payment for performance exists
in order to recognize revenue over time as opposed to
a point in time. This new method aligns better with the
Uniform Commercial Code, which governs the legality of
product sales via customer contracts.
Bill-and-hold arrangements: The new standard will
require manufacturers that have met the criteria for bill-
and-hold arrangements to recognize the warehousing of
those goods as a separate performance obligation. This
implicit warehousing service would be recognized as
revenue over time. This new treatment may actually delay
current revenue recognition as under current guidance
manufacturers that have met the criteria for bill-and-hold
arrangements typically recognize the full contract price
once the product is ready for customer pick up.
Services: As mentioned above, if a company offers
services bundled within a customer contract for the
sale of a good, it may be required to recognize such
services as a separate performance obligation. Services
are typically recognized over time, but not always, using
a measure of progress that best depicts the transfer of
control of the services to the customer.
WARRANTIES AND FINANCING
Under the new standard, add-ons to contracts, such
as warranties and long-term financing, will need
to be assessed to determine if they meet the new
requirements for service-type warranties and significant
financing components.
Warranties: Most manufacturers offer basic warranties
with their products. Typically these will provide customers
with a one-year assurance that guarantees the company
will bring the purchased item back to its original
functionality if it’s not functioning as originally intended.
In addition, many companies, such as outdoor equipment
manufacturers, offer services above and beyond only
covering basic assurance-type service repairs in an effort
to nurture and develop customer relationships, despite
what the basic warranty contractual terms outline. If
manufacturers, in practice, are providing warranty service
repairs above and beyond only those that bring a product
to its basic functionality (assurance-type warranties), then
the company may implicitly be providing customers with
service-type warranties.
Service-type warranties, under the new guidance, are to
be treated as separate performance obligations requiring
a contract’s transaction price to be allocated to them
resulting in deferring revenue recognition and creating
a contract liability. Management must use caution and
judgement when estimating the allocation of a contract’s
transaction price to such performance obligations.
Oftentimes service-type warranties have separate
contract terms represented by an “extended warranty”
offer. Such separate contracts would require separate
revenue recognition, consistent with current practice. The
most significant change is that the new guidance does not
require warranties to be separately priced and written to
be deemed service-type warranties. Rather, a company’s
business practices in the type of service repairs actually
performed in practice would also need to be considered.
Accounting departments will need to ensure they are
communicating with customer service departments
to properly understand the nature of the service
repairs offered to customers under basic and extended
warranties. If companies offer customers generous
warranty service repairs, despite more limited
contractual obligations, in an effort to build strong
customer relationships and brand identity, they may
be required to account for such warranties as separate
performance obligations.
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Significant financing: Manufacturers of large products,
such as heavy equipment and machinery, may offer
a significant financing component to customers. This
is implicit within a contract if payment terms extend
beyond one year from the date control of the product
was transferred to the customer. Most often interest
rates are contractually agreed upon and explicitly stated;
however, they may not represent the market rate of
interest for similar customers with comparable credit
risk. Some companies may not change interest rates to
reflect market and credit risk changes as it can be rather
complex to do so. However, the new guidance suggests
that appropriate interest rates be used to discount the
present value of future payments for customers with
similar credit risk, despite the contract’s explicitly stated
interest rate. Companies should apply market rates as
the implicit rate under such long-term arrangements.
Consideration of materiality will be a factor in these
situations as most rates will likely be materially accurate,
not requiring the complexities of determining a more
appropriate market rate of interest.
CONTRACT COSTS
Incremental costs to obtain and fulfill contracts with
customers are required to be capitalized under the new
revenue standard. Current revenue standards allow
companies to make an accounting policy election to
capitalize such costs; however, most companies expense
such costs as incurred in practice.
Costs to obtain contracts: Incremental costs of obtaining
a contract with a customer, assuming the company
expects to recover those costs, will now be required to
be recognized as a contract asset. “The incremental costs
of obtaining a contract are those costs that entity incurs
to obtain a contract with a customer that it would not
have incurred if the contract had not been obtained.”4
The most common example of such costs are sales
commissions paid for acquiring the customer contract.
How companies pay and offer sales commissions differ
vastly; therefore, careful consideration and judgement
will be required to determine only the incremental costs
related to obtaining the contract and the related amount
of the contract asset. For example, if a sales commission
is paid in installments that are contingent on future
events, then judgement will be required to determine
whether such contingencies will be met. Other complex
areas requiring judgement are commissions on contract
renewals or modifications, commission payments that
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are subject to “clawback” or thresholds, the timing
of when commissions are awarded, and whether
commissions are based on a percentage of all future
sales for a specific customer.
These new contract assets will be required to be
amortized, on a systematic basis, which best reflects
the pattern of the transfer of goods and services of the
underlying customer contract. As a practical expedient,
these contract costs may be recognized as an expense
when incurred if the amortization period of the asset is
one year or less.
Costs to fulfill contracts: Costs incurred in fulfilling
a contract with a customer will now be required to
be recognized as a contract asset. Such costs must
relate directly to the contract and generate or enhance
resources used to satisfy future performance obligations
under the contract. Some examples might include costs
that are explicitly chargeable to the customer under the
contract or costs that are incurred only because of the
contract, such as payments to subcontractors directly
working on fulfilling the contract.
These new contract assets will be required to be amortized,
through amortization expense, on a systematic basis,
which best reflects the pattern of the transfer of goods
and services of the underlying customer contract. In
contrast to costs to obtain a contract, the FASB does not
offer a practical expedient for costs to fulfill contracts
when the amortization period is one year or less.
As most manufacturers will recognize product sales
at a point in time, this practical expedient will likely be
available to most manufacturers. Use of the practical
expedient is an accounting policy election and requires
disclosure in the notes to the financial statements.
CUSTOMER CONTROL
Current revenue standards require that the risks and
rewards of ownership be transferred to the customer
under a sales transaction before revenue can be
recognized. The new standard requires that the customer
has obtained control of the product or benefit of service
before revenue can be recognized.
Recognition upon control: The FASB indicates that
control should be viewed from the customer’s perspective.
Therefore, consistent with current best practices, it
would be appropriate for companies to include customer
acceptance in their internal controls over financial
reporting to ensure customers indicate control of an
asset before recognizing revenue related to such sales.
Where this may become difficult to determine relates to a
manufacturers’ shipping terms with customers.
Oftentimes manufacturers ship products under FOB
shipping terms, covering damages in transit, known as
synthetic FOB destination. As customer acceptance has
not been achieved until delivery is complete, companies
will recognize the full transaction as revenue once it
has been delivered and accepted by the customer. If
customer control is established upon delivery to the
carrier, as may be the case under FOB shipping, then the
new standard would consider the shipment as a separate
service for protection against the risk of damage or loss,
resulting in a separate performance obligation. Therefore,
this may allow companies under such arrangements
to recognize the portion of the consideration related
to the product sale upon shipment and the remaining
consideration related to shipping to be recognized
upon delivery. In such cases, a practical expedient is
available that will allow a company the option to treat
shipping and handling as a fulfillment activity (not as a
separate performance obligation) when shipment occurs
subsequent to customer control of the product.
As this is one of the most significant areas of judgement in
determining when to recognize revenue, it is best practice
to ensure companies have strong internal controls over
financial reporting to support customers have obtained
control of goods or services before recognizing revenue.
As most manufacturers will recognize revenue at a point
in time, special consideration should be made for sales
near the end of reporting periods to ensure proper cut off
of revenue recognition.
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ADOPTION STRATEGIES – MODIFIED
RETROSPECTIVE METHOD
To make the transition to the new standard easier,
the FASB is allowing companies to use a modified
retrospective method in the year of adoption. This
allows companies to apply the new revenue standard
only to the current-year financial statements. To use this
method (for nonpublic companies), any contracts that
are open or new will be subject to the new standard’s
requirements as of January 1, 2019. Contracts that have
been completed or are substantially complete at that
date may be excluded. Those contracts that are partially,
not substantially, complete will require a cumulative-
effective adjustment to the opening balance of retained
earnings on January 1, 2019. In addition, dual reporting
will be required to account for revenue recognition under
current GAAP standards to disclose to users the financial
statement line item differences between the old and new
GAAP revenue recognition standards.
Adoption and effective implementation will most likely
be a significant and time-consuming process for most
enterprises. To keep implementation costs managed,
effectively align other dependent processes, and reduce
the likelihood of future errors and financial statement
restatements related to revenue recognition, companies
need to start planning for this change now, starting with
the following actions:
• Properly identify contract terms and revenue streams.
• Identify areas requiring key estimates and judgments.
• Identify all performance obligations within contracts.
• Identify where variable consideration and constraints on
revenue will be required.
• Identify the allocation of transaction prices to each
performance obligation.
• Identify data that is not currently available impacting key
estimates and judgments.
• Identify the nature of the service repairs provided to
customers related to warranties.
• Identify shipping terms and when control is transferred
to a customer (from the customer’s perspective).
• Identify processes and controls, technology
enhancements and investments, and human resources
needed, including capital and operating budgeting
requirements.
• Begin researching and gathering more information
about the new standard.
NEW DISCLOSURE REQUIREMENTS
The new revenue standard’s disclosure requirements
are much more comprehensive and complex than
the current standard’s requirements. The FASB’s
objective in expanding disclosure requirements was to
provide users more useful quantitative and qualitative
information regarding revenue recognition. Current
standards were vague, leading most companies to adopt
boilerplate language to represent revenue recognition
disclosures. As some companies might be privileged
only in experiencing minor impacts in accounting for
revenue under the new revenue standard, all will be
impacted by the new disclosure requirements. The
disclosure requirements outlined below are addressed to
nonpublic companies as the FASB has granted nonpublic
companies many practical expedients to avoid complex
and costly disclosure requirements.
Disaggregation of revenue: Companies will be required
to present or disclose separately revenue from its
contracts with customers, revenue in accordance with
Accounting Standards Codification Topic 606, and those
revenue transactions accounted for in accordance with
other accounting standards. The new standard “requires
an entity to [also] disaggregate revenue from contracts
with customers into categories that depict how the
nature, amount, timing and uncertainty of revenue and
cash flows are affected by economic factors.”5 Examples
include major product lines, geographical regions, types
of customer classes, types of contracts, contract duration
(short-term and long-term contracts), timing of transfer
of goods or services (point in time versus over time), and
distribution channels.
Nonpublic companies are granted relief; they may
elect not to apply this new quantitative disaggregation
of revenue disclosure requirement. However, if a
nonpublic company elects not to quantitatively disclose
disaggregated revenue, it will still be required to
provide qualitative information about how economic
factors (examples provided above) affect the nature,
amount, timing, and uncertainty of revenue. Qualitative
information should avoid boilerplate language and
be specific to each company’s customer contracts.
Furthermore, nonpublic companies will still be required
to disaggregate revenue according to the timing of
revenue recognition (point in time versus over time).
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Judgements and estimates: More expanded qualitative
information is again required when disclosing the
following:
1. When performance obligations are typically satisfied
2. Significant payment terms
3. The nature of goods or services promised
4. Obligations for returns or refunds
5. Warranties
Other: Additional disclosures will be required as follows:
1. Contract assets
2. Amount allocated to open performance obligations at
year-end
3. Use of practical expedients
4. In year of adoption, financial statement line item
impacts between current and new GAAP revenue
recognition standards (assuming modified
retrospective approach)
These new disclosures are requiring management to
provide transparency in how performance obligations are
determined and what promises are made to customers.
The new revenue standard also requires disclosure of
when performance obligations are typically satisfied
(shipping terms, point in time versus over time, etc.). As
described in Parts I and II, most of these areas will require
significant management judgement as they might have an
implicit nature to them, requiring consideration of business
practices in conjunction with contractual terms. If variable
consideration (Part I) is determined, how management
identified, estimated, and allocated the consideration
to its performance obligations, as well as changes in the
transaction price, will need to be disclosed. If extended
payment terms are offered, any significant financing
components will be need to be disclosed. Expanded
disclosures on returns or refund policies should be
assessed for disclosure and whether any material rights
are granted to customers. Furthermore, the nature of the
service repairs offered under warranties and any estimated
contract liabilities for warranties will need to be disclosed.
Obviously, these vast new disclosure requirements
might trigger concerns with executive management as
to what information is being shared with vendors and
customers. Customers requesting financial statements
may now gain insight into the different types of customer
discounts offered to other customers (material rights
versus marking offers addressed in Part I). Management
should begin assessing these impacts now to best plan
for how disclosures should be strategically presented
while maintaining compliance requirements.
The methodology and judgements used to determine
estimates in all significant areas of recognizing revenue
from contracts with customers will require disclosure.
Judgements provided in disclosures will need to be
supported by good historical data. To prepare for these
new disclosure requirements, management should
assess whether current IT systems are capable to support
good estimates in these areas.
CONCLUSION
This new GAAP standard will require manufacturers
to use more developed judgements and estimates in
applying the five-step framework to customer sales,
which ultimately drives when and how revenue will be
recognized. The new standard will likely significantly
impact financial statements and disclosures, internal
controls over financial reporting, sales processes and
procedures, sales contract provisions, and business
practices. Nonpublic companies should start assessing
their current revenue streams and customer contracts
and determine the reliability of customer data to ensure
historical data can be used to develop new judgements
and estimates. Part II of this article presents additional
specifics of the new standard. Part III of this article covers
the new disclosure requirements.
EKS&H helps manufacturers with a range of issues, including
accounting, tax, audit, technology, and talent. We have more
than 300 manufacturing clients and are active members
of many industry organizations, including the Colorado
Advanced Manufacturing Alliance (CAMA) and the National
Association of Manufacturers (NAM).
To learn more about how EKS&H can help your
manufacturing company adjust to these GAAP changes,
please contact Kreg Brown at [email protected]
or Ben Milius at [email protected], or call us today at
303-740-9400.
Revenue from Contracts with Customers: Significant New Changes for Manufacturers
In this white paper we introduce areas of impact in pricing and discounts, product and service bundling, and recognizing revenue over time. In Part II, we address changes in warranties, contract costs, and customer control as well as adoption requirements. In Part III, we cover new disclosure requirements.