What’s Changed, How it Impacts You, and the Steps You Should Take
It has been nearly five years since the official issuance of the new revenue recognition standard, officially titled Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). With the implementation date for most companies already behind us, many businesses may find themselves significantly behind in their implementation. Some manufacturers have not established a plan for implementation, do not have an idea of how the standard will impact their company, and have not begun to evaluate their contracts with customers. For numerous companies, the impact will be significant and may require the allocation of resources, both internal and external.
What’s Changing Under the New Standard
As a refresher, the new revenue recognition standard is a complete overhaul of previous guidance; that is, it supersedes current literature. Previous guidance was targeted towards specific transactions that caused guidance to become industry specific, complex, and fragmented. Ultimately, this created inconsistencies in revenue recognition across companies and industries.
The current standard is effective for nonpublic companies with reporting periods beginning on or after December 15, 2018, or January 1, 2019 for companies with a calendar year end. The new guidance provides the following five-step model for recognizing revenue under the core principle to “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.”
- Identify the contract(s) with a customer
- Identify the performance obligation(s) in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligation(s) in the contract
- Recognize revenue when (or as) the entity satisfies a performance obligation
1. Identify the Contract(s) with a Customer
The standard defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations.” A contract does not have to be written but it must identify the parties involved, including the rights and obligations of each party and payment terms, have commercial substance, and collection of the consideration or payment must be probable. Contracts can take many forms under the new standard such as purchase orders, emails, customer terms and conditions, formal arrangements, or even a verbal arrangement.
2. Identify the Performance Obligation(s) in the Contract
Once a contract or group of contracts is determined to exist, performance obligations should be identified. In other words, the distinct goods, services, and obligations being provided to complete the contract need to be identified. Performance obligations can be employed by any party to the contract and should be based on the terms of the contract and customary business practices.
3. Determine the Transaction Price
The transaction price is the amount of consideration that will be entitled in exchange for transferring the promised goods or services to the customer. The standard provides several matters to consider when determining the transaction price, namely a concept called variable consideration. Variable consideration includes items that ultimately impact the amount that will be collected, such as discounts, refunds, rebates, customer incentive or loyalty programs, warranties provided with the product (e.g., warranties not purchased by a customer separately), and more. Under the new standard, variable consideration reduces the transaction price (e.g., variable consideration will be reported net of sales), which may be different than where companies currently report these items.
4. Allocate the Transaction Price to the Performance Obligation(s) in the Contract
Once the transaction price is determined, the price must be allocated to the performance obligations that were identified in step two on a relative standalone selling price basis. The transaction price should be allocated to each performance obligation as if the performance obligations were sold separately. Variable consideration should be allocated to their respective performance obligations.
5. Recognize Revenue when (or as) the Entity Satisfies a Performance Obligation
Finally, revenue can be recognized upon the satisfaction of each performance obligation through the transfer of control of a promised good or service (as opposed to a transfer of risk in current guidance).
Custom Contract Manufacturers
Companies who manufacture customer-specific and customized goods may be greatly impacted by this standard, so long as they have the right to receive payment and the products are considered to have no alternative use. Because the core principle of the standard is focused on the transfer of control rather than the transfer of risk, the transfer of control may occur before risk of loss. Accordingly, the timing of recognizing revenue may change from recognizing revenue at a point in time (e.g., shipping point) to recognizing revenue over-time (e.g., percentage of completion as goods are produced). This concept generally accelerates revenue recognition, as revenue is now recognized as the goods are produced (e.g., over-time as the control over what can be done with the product is transferred to the customer) rather than when shipped (e.g., a point in time as the risk of loss is transferred to the customer).
In evaluating whether to recognize revenue over-time rather than at a point in time, businesses must consider whether the production process creates an asset with no alternative use. Essentially, is the end product custom enough that it can only be sold to the specific customer who ordered it? Some manufacturers may make a product that has a basic design across all contracts; however, significant customization is performed during the process. In this case, the base design may be able to be sold or redirected to other customers at a point in the process, even when the ultimate product cannot. In this case, even if a product can be sold to a different customer throughout the production process but the end product cannot, revenue should begin to be recognized over time as soon as production begins, not when the product converts from the base design to the customized good. In other words, the timing of when a product becomes customized does not matter when evaluating how to recognize revenue. The literature requires the use of judgment when applying the concept of a product having no alternative use, and states that if the asset that is ultimately transferred could be redirected without a significant cost of rework, then is it determined to have alternative use and should follow other guidance within the standard.
Many manufacturers enter into bill-and-hold arrangements with customers whereby the company bills a customer for a product but retains physical possession. These arrangements are typically entered into because of production delays or lack of available space at the customer’s location. Previous guidance was silent regarding bill-and-hold agreements; however, industry practice was to follow guidance issued by the Securities and Exchange Commission. This required the company to meet a specific set of criteria prior to the recognition of revenue, including the requirement for a fixed delivery schedule from the customer.
The new revenue recognition standard provides specific guidance that must be met to recognize revenue under a bill-and-hold agreement. The new standard does not require a fixed delivery schedule from the customer, which may accelerate revenue. To recognize revenue under a bill-and-hold arrangement, the company must first have satisfied its performance obligation to transfer a product by evaluating when the customer obtains control under the contract identified. If the entity has satisfied its performance obligation, all of the following criteria must be met:
- The reason for the bill-and-hold arrangement must be substantive (e.g., the customer has requested the arrangement)
- The product must be identified separately as belonging to the customer
- The product currently must be ready for physical transfer to the customer
- The entity cannot have the ability to use the product or to direct it to another customer
Companies that frequently enter into bill-and-hold agreements should review their current arrangements and ensure they follow the guidance in the standard to ensure they are able to recognize revenue under the new standard.
What Steps Manufacturers Should Take Now
1. Evaluate current revenue practices and customer agreements
The identification of all contracts will take input from sales and operations teams. Additionally, it will be important to identify all performance obligations in each contract. Items such as warranties and shipping services can now be considered separate performance obligations depending on the circumstances of the arrangement.
2. Evaluate information technology (IT) systems
In some cases, the recognition of revenue will require new information. Businesses should evaluate current IT systems to ensure those systems can provide the information necessary to recognize revenue under the new standard. Items such as contract inventory, identification and tracking of numerous performance obligations, and the allocation of transaction price to various performance obligations may be unsupported by current systems. The standard requires additional disclosures that contain information that may not have been tracked historically including disaggregation of revenue, information about contract balances and performance obligations, and significant judgments related to performance obligations and transaction prices.
3. Review covenants
The standard changes the core principle of how revenue is recognized, which can impact financial covenants. Early, transparent discussions with your lender and stakeholders can help ensure your organization isn’t negatively impacted by the new revenue recognition guidance.
4. Review compensation structure
Sales commissions may be impacted by the timing of revenue recognition under the new standard. Current compensation plans should be evaluated to determine if adjustments are required.
5. Review transition methods and plan for transition
The standard allows for one of two methods of adoption: full retrospective or modified retrospective. Full retrospective requires retrospective application for all periods presented, with the option to elect certain practical expedients. Modified retrospective requires the cumulative effect of applying the guidance recognized as of the date of initial adoption and involves certain additional disclosures. Because implementation may have already been effective January 1, 2019, companies may need to evaluate whether they have the appropriate information to evaluate contracts in process at the date of transition or if information may need to be recreated.
6. Consult with your trusted advisors (accountants, lenders, and stakeholders) and create an action plan for implementation
Companies should talk to their accountants, auditors, lenders, stakeholders, and other users of their financial statements regarding the impact this standard has on their company. Companies should create an action plan to implement this standard and be proactive in their approach to implementation.
The guidance included in ASU 2014-09 (ASC 606) is significant and involves many other issues and topics beyond what was described above. The implementation of the standard will involve input from many individuals, advisors, and departments. Sikich has a dedicated revenue recognition committee and manufacturing and distribution team committed to understanding the new standard and educating those it will impact. Please contact us to discuss your unique situation.
About the Author
Allan Lyon, CMA, CPA, MSA
Senior Audit Manager
Allan provides audit and accounting services and serves a variety of middle-market manufacturing and distributing clients. He is directly involved in resolving assurance and business operational concerns and works closely with upper management. Allan works as a consultant with clients in the areas of assurance, operations, inventory management, internal controls, strategic planning and financing.