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Why smart manufacturers review their contracts

11/30/2015

Manufacturers and distributors may enter into various types of long-term contracts, including property and equipment leasing, raw materials, confidentiality, exclusivity and joint venture agreements. You should review these contracts on a regular basis to ensure that the agreements remain enforceable, compliant and financially advantageous. Now the Financial Accounting Standards Board (FASB) has introduced another reason to check up on your long-term contracts.

Hidden treasure hunt

Begin your formal contract review by identifying all major legal contracts. Here are the next steps:

  1. Read contracts to determine whether terms and conditions have been met and necessary information is included and updated.
  2. Revise or renegotiate incomplete or expired agreements.
  3. Create a tracking system to identify expiration dates and other events that might invalidate an agreement.
  4. Brainstorm ways to save more money, such as negotiating early-bird discounts from suppliers or bundling contracts to achieve economies of scale.

To illustrate, a custom tool and die shop hired a CPA to review its contracts and discovered that it wasn’t charging customers for change orders in accordance with its standard customer contract. The CPA helped implement a change-order monitoring system to improve communications between machinists who handle the change orders and the billing department.

Updated revenue recognition guidance

In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, which modifies when companies recognize revenue from long-term contracts and requires more detailed footnote disclosures. Manufacturers and distributors will generally report the same total amount of revenue under the existing and updated guidance.

But the updated accounting standard will alter the timing of revenue recognition, because it requires companies to estimate the effects of variable consideration, such as sales incentives, discounts and warranties. It also could create differences in book and tax recordkeeping.

On July 9, the FASB delayed implementation of the new standard for another year — until 2018 for public companies. But companies that issue comparative financial statements will need to start tracking the changes as soon as possible to meet the FASB’s retrospective application requirements.

In addition, many companies are uncertain exactly how to apply the principles-based revenue recognition standard to their contracts. In some cases, management may decide to modify contract terms and conditions to facilitate compliance with the recent FASB update.

Outside assistance

Today’s business contracts tend to be detailed and complex, so it’s helpful to hire outside professionals to review them with a fresh set of eyes. Often these professionals pay for themselves with the cost savings and risk mitigation that formal contract reviews provide.