In 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, created changes to how companies will recognize and disclose their revenue from contracts with customers. The goal of this change was to better align U.S. generally accepted accounting principles (GAAP) with international financial reporting standards and create a more robust framework to address revenue issues.
The purpose of the FASB’s new guidelines is that companies will recognize revenue in a way that more clearly communicates the transfer of goods or services to customers in an amount that reflects when customers can use the goods or services provided.
The new guidance is based on a five-step framework:
- Identify contract with the customer.
- Identify performance obligations.
- Determine transaction price.
- Allocate transaction price to performance obligations.
- Recognize revenue when (or as) entity satisfies a performance obligation.
In many cases, manufacturing companies need to make significant changes to their internal controls over financial reporting, financial statements and disclosures, sales processes and procedures, sales contract provisions, and business practices. 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.
The following are areas most likely to impact manufacturing companies:
Pricing and Discounts
Variable consideration: Management will be required to use judgments and estimates to determine the amount customers will pay for customer sales and must assess whether it’s probable a significant revenue reversal may occur prior to recognizing revenue from a contract. If probable, significant revenue reversals should be estimated and constrained against variable consideration recognized.
Customer options for additional goods and services: Material rights must be treated as separate performance obligations since the customer is implicitly paying in advance for future goods. Management must 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. The amount of the transaction price allocated to the material right will be recognized as revenue once either the performance obligation has been satisfied or the discount expires.
Products and Services Bundling
Identifying performance obligations: Manufacturers that offer an installation service or bundled goods within customer contracts might be required to recognize such services or goods as separate performance obligations.
Recognizing Revenue Over Time
Specialized and customized products: Customized products will have no alternative use, and an enforceable right to payment for performance will exist to recognize revenue over time as opposed to a point in time.
Bill-and-hold arrangements: Manufacturers that have met the criteria for bill-and-hold arrangements must recognize the warehousing of those goods as a separate performance obligation.
Services: If services are bundled within a customer contract for the sale of a good, it may be required to recognize such services as a separate performance obligation.
Warranties and Financing
Warranties: If manufacturers are providing warranty service repairs above and beyond only those that bring a product to its basic functionality, they may implicitly provide customers with service-type warranties.
Service-type warranties will be treated as separate performance obligations, requiring a contract’s transaction price to be allocated to them, deferring revenue recognition, and creating a contract liability.
Warranties aren’t required to be separately priced and written to be deemed service-type warranties. A company’s business practices in the type of service repairs actually performed in practice must also be considered.
Significant financing: Appropriate interest rates should 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.
Costs to obtain contracts: Incremental costs of obtaining a contract with a customer (if the company expects to recover those costs) will be required to be recognized as a contract asset.
New contract assets will be required to be amortized, through amortization expense, on a systematic basis to best reflect the pattern of the transfer of goods and services of the underlying customer contract.
Costs to fulfill contracts: Costs to fulfill a contract with a customer will be required to be recognized as a contract asset. These must be amortized, through amortization expense, on a systematic basis to best reflect the pattern of the transfer of goods and services of the underlying customer contract.
Recognition upon control: View control from the customer’s perspective. Companies should include customer acceptance in internal controls over financial reporting to ensure customers indicate control of an asset before recognizing revenue related to such sales.
Adoption Strategies – Modified Retrospective Method
Companies can use a modified retrospective method in the year of adoption. They can apply the new revenue standard only to the current-year financial statements.
For nonpublic companies, any contracts that are open or new will be subject to the new standard’s requirements as of January 1, 2019. Complete or substantially complete contracts may be excluded. Partially complete contracts will require a cumulative-effective adjustment to the opening balance of retained earnings on January 1, 2019. 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.
New Disclosure Requirements
Disaggregation of revenue: Companies must separately present or disclose revenue from its contracts with customers, revenue in accordance with Accounting Standards Codification Topic 606, and revenue transactions accounted for in accordance with other accounting standards. (Nonpublic companies aren’t required to apply the disaggregation of revenue disclosure requirement.)
Judgments and estimates: More expanded qualitative information is required when disclosing:
- When performance obligations are typically satisfied
- Significant payment terms
- Nature of goods or services promised
- Obligations for returns or refunds
Other: Additional disclosures will be required as follows:
- Contract assets
- Amount allocated to open performance obligations at year-end
- Use of practical expedients
- In year of adoption, financial statement line item impacts between current and new GAAP revenue recognition standards
Management must be transparent about how performance obligations are determined, what promises are made to customers, and disclosure of when performance obligations are typically satisfied.
If extended payment terms are offered, significant financing components must be disclosed. Expanded disclosures on returns or refund policies should be assessed for disclosure and if any material rights are granted to customers.
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.
Kreg Brown, CPA, is an audit partner and Ben Milius, CPA, is an audit manager, both with EKS&H.