The final touches are being put on the new single, principles-based standard that will update and converge revenue recognition under the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board. The change will impact entities that use US generally accepted accounting principles (“GAAP”) or International Financial Reporting Standards (“IFRS”). FASB describes the need for improvement in this area as follows:
“Revenue is a crucial number to users of financial statements in assessing an entity’s financial performance and position. However, revenue recognition requirements in…GAAP differ from those in…IFRSs, and both sets of requirements need improvement. U.S. GAAP comprises broad revenue recognition concepts and numerous requirements for particular industries or transactions that can result in different accounting for economically similar transactions. Although IFRSs have fewer requirements on revenue recognition, the two main revenue recognition standards, IAS 18, Revenue, and IAS 11, Construction Contracts, can be difficult to understand and apply. In addition, IAS 18 provides limited guidance on important topics such as revenue recognition for multiple-element arrangements.”
Key goals in addressing these issues include clarity, simplification, and consistency/comparability across not only entities, but also industries, jurisdictions and capital markets. The new principles-based approach indicates
“an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
To achieve that core principle, an entity would apply all of the following steps:
1. Step 1: Identify the contract with a customer.
2. Step 2: Identify the separate performance obligations in the contract.
3. Step 3: Determine the transaction price.
4. Step 4: Allocate the transaction price to the separate performance obligations in the contract.
5. Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.”
Each of these steps contains specific practices which must be followed. Additional disclosures are also required, including discussion of significant judgments and reconciliations of contract balances with customers.
Even though the actual implementation of the standard will not be effective immediately, the significant changes in reporting and necessary assessment of related processes mean that it would be wise to begin analyzing how this implementation can be achieved smoothly. For instance, compliance with the standard’s new framework regarding contract modifications may be a monumental task for those with long term contracts. Supporting estimates of selling price may require policy-making efforts and detailed underlying analysis. New internal controls and IT functionality will likely be necessary to ensure compliance with the new standard.
In addition, companies should be thoughtful regarding how this affects areas outside of GAAP/IFRS based financial reports. Profitability estimates and targets will need to be revisited. Policies in place to further corporate goals, such as commission structures, should be re-examined to ensure they continue to be aligned with the company’s motivations under the new revenue standard and reward behavior accordingly. Loan covenants should be reviewed to determine what impact the new rules will have on lending agreements (and preferably addressed before any non-compliance scenario occurs). Legal questions may also arise as to how this impacts such issues as payment of earn-out agreements negotiated under prior accounting rules. Like any major change, this new revenue standard will likely involve a difficult transition period for many companies and requires the appropriate advance preparation.