In May 2014, the Financial Accounting Standards Board (FASB) in conjunction with the International Accounting Standards Board (IASB) developed a converged revenue recognition standard. Accounting Standards Update 2014-09, Revenue from Contracts with Customers
, which is ASC 606 in the FASB Codification, will replace decades-old ASC 605. ASU 2014-09 moves away from the many levels of industry-specific and transaction guidance toward a broader, principles-based approach. Many may welcome the replacement of narrow-scope specifics found in the current revenue recognition model, but it must be noted that it is being replaced with a model that significantly increases the amount of judgment in the revenue recognition for many industries.
The new model incorporates a five-step process for determining revenue recognition:
- Identify the contract with the customer.
- Identify the performance obligation in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when the entity satisfies a performance obligation.
The five criteria under ASC 606 for revenue recognition do not appear on the surface to be a drastic change from the current guidance, which is as follows:
- Persuasive evidence of an arrangement exists.
- Delivery has occurred or services have been rendered.
- The price is fixed or determinable.
- Collectability is reasonably assured.
The new revenue model defines a contract as an agreement between parties that creates enforceable rights and obligations. A contract must have commercial substance, and the new standard introduces probability of the amount that will be collected under the contract, which may be less than the contractual arrangement.
At the onset of an arrangement, an evaluation is needed to determine if the promised goods and services are distinct. The new standard defines goods or services as being distinct if the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer. The FASB stated in the basis for conclusion that its intent in the new standard was not that an entity would identify significantly more performance obligation than under the existing guidance. However, companies will need to have adequate documentation for their respective accounting treatment as single-performance obligations or multiple-performance obligations. Customer service arrangements and loyalty programs are two areas that may be affected by the new guidance.
Another component of the new standard is determining the transaction price. This is the amount of consideration an entity expects to receive in exchange for goods and services, which an entity will determine at the onset of the contract. This is an area that will require significant judgment and support for a company’s revenue recognition, especially when a company includes variable consideration in its revenue arrangements.
Variable consideration includes items such as discounts, rebates, refunds, right of return, and performance bonuses and penalties. The new standard allows companies to use two methods to determine the variable consideration: either the expected value method (which is a probability-based measure) or the most likely amount. No matter which method is used, significant judgment will be involved and the company will need to have documentation of the basis for that judgment.
The fourth step in the new model is to allocate the transaction price to each performance obligation. Contracts that contain multiple performance obligations will require a two-part analysis. The first part is to determine the stand-alone selling price. ASU 2014-09 defines the stand-alone selling price as the price at which an entity would sell a promised good or service separately to a customer. The best evidence of a stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately under similar circumstances and to similar customers. If the stand-alone selling price is not an observable price, the company will need to develop an estimated selling price that requires judgment and documentation. This process is similar to what is currently done for entities that have multiple element arrangements. The new standard provides more flexibility than current guidance in determining the stand-alone selling price.
Finally, the new standard recognizes revenue as the entity satisfies the performance obligation. An entity will either recognize revenue as the performance obligation is satisfied or over the contractual period. The over-time criteria are similar to the current guidance for construction-type contracts without the industry-specific rules.
This overview of the new revenue guidance does not begin to address its myriad complexities, nor does it address the implementation issues associated with company implementation. The standard has been a hot topic since its release three years ago, and time is running out for companies to determine its impact on their revenue processes. Public companies will have to adopt the new standard in 2018, and most private companies will follow in 2019.
ASU 2014-09, when released, was over 700 pages. With additional guidance being released by the FASB, the entire authoritative literature is close to 1,000 pages. While some industries will see little impact from the timing of the recognition and the measurement for their revenue processes, many other industries, as you can see above, will see dramatic changes. All companies will be affected by the substantial increase in disclosure as it relates to their revenue recognition policies.
The intent of this overview is to highlight the significant increase in judgment that will be required for adoption. The new standard will be especially challenging during the initial adoption period, and if not properly managed, could result in negative consequences for management in relation to the audit process. The new model is much more principles-based, and as such will require robust documentation of the significant judgments that management will use to determine the appropriate revenue recognition. That documentation will need to be supported for an outside auditor to be able to opine on the financial statements. If documentation does not exist, it could result in a modification of the auditor’s report or a material weakness, both of which could negatively affect the company with lenders, regulators, and other stakeholders.
Companies need to understand the impact the new standard will have on their control environment and related policies. While many private companies often have less robust control environments and related documentation, this is still a critical component in an auditor’s assessment of risk. Failure to appropriately modify the control environment and institute key controls around significant assertions will result in material weaknesses being part of an auditor’s required communications. Those communications often are shared with lenders, regulators, and other interested stakeholders.
Another potential hazard is the belief that outside auditors will be able to guide companies through the new revenue model. While an outside entity certainly should be a key part of any transition or implementation plan for the new revenue recognition standard, the auditors cannot significantly drive the process of adoption. In December 2014, the AICPA updated its Code of Professional Conduct. The update requires that threats and safeguards are appropriately identified and in place to ensure independence. However, some threats are of such nature that no appropriate safeguard can be instituted. Regulators have made maintaining auditor independence a key issue in the oversight process.
As companies implement the new standard, it is a good time to remember that revenue recognition contains the risk of fraud in the audit process. The auditing standards in AU 316, Consideration of Fraud in a Financial Statement Audit
, paragraph .06, highlight the two types of misstatements that are relevant to auditors: misappropriation of assets and misstatements arising from fraudulent financial reporting. While understanding that not all fraudulent financial reporting is due to fraud, the risk is heightened when dealing with revenue recognition.
The new standard will have a drastic impact on companies and their financial reporting process, and the long transition period has become suddenly imminent. Many are hoping for additional deferral, but the FASB, as recent as the 2017 AICPA National Advanced Accounting and Auditing Technical Symposium, which was part of AICPA ENGAGE 2017, indicated that no further deferral was likely. This is consistent with FASB’s responses in other forums.
The business headlines on this topic continue to show the significant work necessary for implementation. There are many practical tools available from the international accounting firms, the PICPA
, and the AICPA. The AICPA, in November 2016, released its Revenue Recognition - Audit and Accounting Guide
. This guide offers detailed guidance to help auditors and preparers deal with the new standard.
Keith C. Peterka, CPA, is a partner with Citrin Cooperman & Company LLP in Philadelphia. He can be reached at email@example.com.