Guide Contents:

  • When is the new standard effective?
  • What does the new standard require?
  • What are some of the more significant changes?
  • Are the new financial statement disclosures required?
  • What are the impacts to my company?
  • What are the methods to transition to the new standard?
  • How does my company begin the implementation process?

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Frequently Asked Questions about Revenue Recognition

Introduction to the New Standard

The new revenue recognition accounting standard, effective for middle market nonpublic businesses starting from fiscal years beginning after December 15, 2018, brings about fundamental changes in how companies recognize revenue. This standard enforces a structured five-step process that companies must follow to appropriately recognize revenue.

The Five-Step Process

  1. Identifying Customer Contracts
    The first step involves identifying the customer contract that forms the basis of revenue recognition. This includes determining the rights and obligations of both parties involved.
  2. Identifying Performance Obligations
    This step requires companies to identify the distinct performance obligations within the contract – essentially, the individual goods or services promised to the customer.
  3. Determining Transaction Price
    Here, companies need to establish the transaction price, which includes consideration of variable amounts, potential discounts, and any non-cash elements.
  4. Allocating Price to Performance Obligations
    In this step, the transaction price is allocated to the various performance obligations identified earlier, based on their relative standalone selling prices.
  5. Recognizing Revenue as Obligations are Fulfilled
    Revenue is recognized as each performance obligation is satisfied, meaning that control of the promised good or service is transferred to the customer.

Shift in Revenue Recognition

One notable change in this standard is the shift from recognizing revenue upon delivery to recognizing revenue when control of the product or service is transferred to the customer. This shift might lead to earlier revenue recognition for some companies, especially in cases where customization is involved.

Variable Consideration and Disclosures

The new standard mandates the inclusion of variable consideration, such as volume discounts and rebates, in the revenue recognition process. Additionally, new financial statement disclosures are required, encompassing disaggregated revenue details, performance obligation information, payment terms, and more.

Impact and Adjustments

The implications of the new standard are far-reaching, affecting areas such as bonus compensation plans, debt covenant compliance, revenue-related business projections, and customer contract analysis. Furthermore, companies must adapt their internal controls to ensure compliance with the new standard.

Transition Methods

Companies have two options for transitioning to the new standard:

  • Full Retrospective Method: This involves applying the standard to all presented periods, with the option to use practical expedients to ease the transition.
  • Modified Retrospective Method: This approach allows companies to apply the standard to the current year while making adjustments for partially completed contracts.

Seeking Expertise for Implementation

To navigate the complexities of implementation, companies can enlist the expertise of firms like LBMC. These professionals can aid in developing an implementation plan, assessing the effects of the standard, and ensuring compliance. Their services encompass contract evaluation, revenue process analysis, internal control adjustments, and impact assessment.

New accounting standards you should know about.

Starting in 2018 for public companies and 2019 for other entities, revenue must be reported using the new principles-based guidance found in Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The updated guidance doesn’t affect the number of revenue companies report over the life of a contract. Rather, it affects the timing of revenue recognition.

IASB & FASB – Streamlining Standards

The purpose of this change is to converge with the International Accounting Standards Board (IASB). The goal is to remove numerous inconsistencies between the FASB and IASB revenue recognition standards. These changes require entities, including not-for-profits, to clearly identify performance obligations in existing contracts, reapportion revenue at each contract revision or change and defer expense recognition to match with the contract’s delivery. With this being the case, contract add-ons and contract renewals must be aligned into a single contract and will prompt reallocations across both past and future periods – which can cause numerous revisions to revenue allocations and expense alignment.

Rule-Based Accounting to Principle-Based Focus

With over 200 revenue recognition standards in the United States, the new principle-based standard focuses on the contract between the entity and consumer for the agreement of services or goods, and it also focuses on the rights and duties between the two parties.

The most important change is there are now five steps in the revenue recognition process.

  1. Identify contracts
  2. Identify the separate performance obligations on the contract
  3. Transaction price determination
  4. Allocate transaction price to the performance obligations in the contract
  5. Recognize revenue when the entity satisfies its performance obligations

EBITDA & Leases

Earnings before interest, taxes, depreciation, and amortization (EBITDA) will be changing as well. This is because the “right to use” asset that is set for the lease is amortized over the lease term. This changes it from an operating expense to a reduction of lease obligation while amortization expenses are recorded to reduce the right to use the asset.

Generally, leases will be on the balance sheet, and it is important to remember that leverage ratios will be changing and liabilities will be increasing. For some entities, this change will be extraordinary. For example, if a company has $500 million in liabilities and $500 million in equity and $200 million in future operating lease obligations, then they would have a leverage ratio of 1:1. In this example, when leases are recorded as a liability on the balance sheet, the leverage ratio would go to 1.4:1, which is a substantial change.

Why does revenue matter in an audit?

When it comes to revenue, auditors customarily watch for fictitious transactions and premature recognition ploys. Here’s a look at some examples of critical issues that auditors may target to prevent and detect improper revenue recognition tactics.

  • Contractual arrangements – Auditors aim to understand the company, its environment and its internal controls. This includes becoming familiar with key products and services and the contractual terms of the company’s sales transactions. With this knowledge, the auditor can identify key terms of standardized contracts and evaluate the effects of nonstandard terms. Such information helps the auditor determine the procedures necessary to test whether revenue was properly reported.
  • Gross vs. net revenue – Auditors evaluate whether the company is the principal or agent in a given transaction. This information is needed to evaluate whether the company’s presentation of revenue on a gross basis (as a principal) vs. a net basis (as an agent) complies with applicable standards.
  • Revenue cutoffs – Revenue must be reported in the correct accounting period, generally the period in which it’s earned. Cutoff testing procedures should be designed to detect potential misstatements related to timing issues, as well as to obtain enough relevant and reliable evidence regarding whether revenue is recorded in the appropriate period. If the risk of improper accounting cutoffs is related to overstatement or understatement of revenue, the procedures should encompass testing of revenue recorded in the period covered by the financial statements and in the subsequent period. A typical cutoff procedure might involve testing sales transactions by comparing sales data for a period before and after year-end to sales invoices, shipping documentation or other evidence. Such comparisons help determine whether revenue recognition criteria were met, and sales were recorded in the proper period.

Considering the new revenue recognition standard, companies should expect revenue to receive renewed attention in the coming audit season. Contact us to help implement the new revenue recognition rules or to discuss how the changes will affect audit fieldwork.

What’s Next for Your Revenue Recognition?

Some recommended steps for businesses to evaluate the ramifications of the new revenue recognition standards are:

  • Inspecting revenue streams and contracts to target the specific revenue changes required and where these changes have the biggest impact
  • Addressing the areas that may take longer to resolve first for the adequate lead time

Automated Solutions

LBMC Technology Solutions understands that navigating through these changes can be a monumental task. This is why we provide solutions that are automated, enabling companies to both manage revenue using current and new guidelines simultaneously. Our programs can offer you the ability to:

  • Automate processes for addressing all new ASC 606 and IFRS 15 rules for revenue reallocation and expense amortization
  • At the transaction level, disclose the impact of changes with surety with automated dual treatment
  • Clearly discern the impact of the new rules on entities results with revenue and expense forecasting
  • Automate complicated subscription billing with full integration to revenue recognition.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.