As a quick recap, the new revenue recognition standard (ASU 2014-09, also known as ASC 606) provides new requirements for recognition of revenue arising from contracts with customers, except in cases where contracts are within the scope of other U.S. GAAP requirements (such as the leasing standards). The standard impacts businesses in all industries and will become effective January 1, 2019 for non-public companies.
Companies may elect one of two methods for implementation: (1) the modified retrospective approach or (2) a full restatement. Revenue amounts and timing may not ultimately change, but disclosure requirements likely will
change. Furthermore, tax treatment will generally need to follow GAAP and considerations will need to be made relative to tax filings as well.
One Size Does Not Fit All
Each provision of ASU 2014-09 will not apply to every company. For example, two manufacturing companies competing in the same marketplace could face different issues, depending on what terms are negotiated in their customers’ contracts. It is important to understand the guidance as it relates specifically to each individual business.
The following is a summary of the five-step process model that companies will need to work through to determine revenue recognition under the new standard. For the purposes of this article, I have added a few areas of interest for manufacturers.
Revenue Recognition Model – Five-Step Process
1. Identify the contract.
All businesses have agreements with their customers. A contract is anything that creates enforceable rights or obligations (contract, purchase order or change order). Approval and commitment of a contract can be in writing, orally or in accordance with customary business practices. The contract needs to also have commercial substance, as defined, have identifiable payments terms, and collection needs to be probable.
Shipping and Handling - Shipping and handling that occurs before a customer obtains control of a product is considered a fulfillment activity. Shipping and handling that occurs after a customer obtains control of a product is considered a promised service. An accounting policy election can be made to treat promised services as fulfillment.
2. Identify the performance obligations in the contract.
Distinct goods or services that have their own value should be separately identifiable from other promises in the contract (that is, explicit and implicit).
Warranty - If a warranty is not separately priced, revenue is recognized in full at the time of delivery and the related cost is accrued. Extended warranties and warranties that provide services other than assurance that a product complies with its specifications, are accounted for as separate performance obligations within a contract.
3. Determine the contract price.
This includes fixed cash consideration, variable consideration, financing components, consideration payable to the customer, and non-cash consideration.
Variable Consideration - Can include bonuses, price concessions, refunds, milestone payments, penalties, discounts, returns, volume rebates, etc. Out-of-pocket costs may also potentially be viewed as variable consideration. The new standard tasks each business with valuing contracts based on a variety of methods, with further guidance included within the standard.
Returns - Revenue is not recorded for refunds expected to be paid to customers. Rather, a refund liability is recorded with a corresponding asset (adjustment to COGS) representing the right to recover products from customers of settling the refund liability.
Gross Versus Net Revenue - The transaction price is the amount of consideration for which the company expects to be entitled (net of discounts or rebates). Companies make an accounting policy election to exclude from the transaction price certain types of taxes collected from customers.
4. Allocate the contract price to performance obligations.
First, allocate transaction price using standalone selling prices for identified performance obligations. If standalone selling prices are not available for certain performance obligations, a company may use available market data. A residual approach may be used for any remainder.
5. Recognize revenue as the performance obligation is satisfied.
Each performance obligation is recognized at a point in time or over a period of time. Over time, recognition is only allowed if any of the following are met:
- Customer simultaneously receives and consumes the benefit.
- Services rendered create or enhance an asset that the customer controls.
- Services do not create an asset with an alternative use to the service provider and the service provider has an enforceable right to payment at all times during the term of the contract.
Milestones - Contractual billing milestones may not be considered performance obligations and are not necessarily indicative of “point in time” recognition.
Short Cycle Manufacturing - Companies may have an enforceable right to payment and under the principal of the new standard would need to recognize revenue. The FASB is already deliberating on an exception for this one, so stay tuned.
Bill and Hold - The new standard provides explicit guidance that is essentially the same guidance in the SEC’s interpretive guidance. Many private companies were already following it; therefore, no change is likely. However, companies may want to revisit the four criteria that must be met for recognition:
- The reason is substantive.
- The product is separately identified.
- The product is ready for physical transfer.
- The company cannot be able to use or redirect the product.
Other Considerations for Manufacturers
In addition to the changes in ASC 606, there are other changes to costs (ASC 340) that are not covered in the five-step model. Those who are responsible for implementing revenue recognition should also take note of the following considerations.
- Costs of obtaining the contract - These are incremental costs incurred as a result of a contract being obtained. Costs are deferred and amortized over the life of the contract (including considerations for renewal), as long as costs are expected to be covered. This includes sales commissions but does not include legal and credit evaluations.
- Contract Fulfillment - The costs of fulfilling a contract should be accounted for under other GAAP standards. Any deferred costs are amortized over the life of the contract (including considerations for renewal) in the same pattern as revenue is recognized. Costs included are equipment recalibration and design costs required to fulfill a contract.
The new model focuses on recognition of revenue and not margin and costs. FASB did not include guidance for abnormal or wasted materials. Use your judgement to adjust for costs that do not contribute to contract progress.
The five-step revenue recognition model may appear straightforward, but it provides a simplified, high-level overview. Most companies will likely have more than one contract that needs to be evaluated. It will take time to capture the information needed to support compliance. If you don’t have one yet, create an implementation team and set up a road map to assess the impact of the new standard.
Public companies were required to adopt the standard in 2018, so private companies will have a window into its impact. Implementation teams should consider evaluating the footnote disclosures of public companies as noted in their quarterly filings and compare to others in the industry as they begin to evaluate how the standard will affect their company.
A CPA firm can help you with this process, and the time to start is now. For more information about implementing revenue recognition standards for manufacturers, please contact Hillary Parker
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