Assessing the Impact of the New Revenue Recognition Standard
Most companies will be required to implement the new revenue guidance, and you as management, board members or audit committee members, should be aware of the process that must be pursued in order to implement the guidance.
After a basic understanding of the new rules is gained, a preliminary assessment of the impact of those rules on your company’s financial reporting should be made. This assessment generally includes 5 steps.
The steps involved in preparing an effective impact assessment are:
- Evaluate which revenue streams are material to the financial statements.
- For each revenue stream, consider the specific elements of the revenue stream and how they would be impacted by the application of the new guidance.
- Consider other factors that may be impacted by the implementation of the guidance.
- Prepare pro-forma financial statements showing the expected impact of the guidance.
- Communicate the expected impact of the guidance to stakeholders.
Considering which revenue streams to assess:
Ideally, and eventually, all revenue streams should be considered in the implementation of the new guidance.
However, for purposes of the impact assessment, companies may wish to consider only those that are material to the financial statements for all periods that are presented. This consideration should include those that are both (a) quantitatively material and (b) qualitatively material.
Companies should also consider those revenue streams that are expected to be material to the financial statements in the future to consider whether they would be qualitatively material to the periods to be presented.
Specific elements to assess for each revenue stream:
The new standard will significantly change how revenue is recognized for many contracts. Terms within those revenue contracts may now have much different implications for the recognition of revenue. Additionally, bright line requirements previously driven by guidance have been softened or changed to allow, or require, recognition based on significantly judgmental factors. Companies should reconsider and evaluate all the terms within a contract (standard or otherwise) to understand their impact. Some things that may impact the recognition of revenue include:
|· Bundled goods and services
· Multiple contracts entered into contemporaneously
· Reward and loyalty programs
· Rebate and co-op programs
· Vendor incentive programs
· Return privileges
· Historical principle and agent considerations and how they are different under new guidance
|· Warranties and guarantees
· Bill and hold programs
· Licenses and royalties
· Long term payment terms
· Construction type and long term contracts
· Variable consideration
· Contract modifications
· Collaboration programs
The list above is by no means an exhaustive list, and companies should consider all terms and conditions, whether explicitly stated or not.
Other factors to consider:
The new guidance has other implications beyond the recognition of revenue. Some of those implications are clearly laid out in the guidance. Other items are not so clearly laid out or are driven by other guidance. The assessment should also consider the impact of these other items when assessing the impact of the guidance. Some of these items are:
- Costs to obtain or fulfill a contract may be capitalized in some situations, and are clearly addressed in the guidance, and the company should include these costs in its assessment.
- Compensation or other revenue-driven contracts, and the accrual and recognition of related transactions, may be impacted by the change in how revenue is recorded. Such amounts should be estimated for the purposes of an overall impact assessment.
- Debt or other covenants may be impacted by the adoption of the guidance, especially financial covenants with earnings or capital based covenants. The company needs to understand these items in order to understand potential impact on ongoing operations and financing arrangements, and to communicate them to those necessary.
- The impact on income tax accounting should be considered.
- Historical deferred revenue may impacted, and expected revenues may be lost or significantly adjusted based on the adoption of this guidance.
Although this list is not complete, the potential impact of this guidance on other matters is significant and may impact numerous areas. Management should consider all items when preparing their impact assessment.
Management may wish to prepare pro-forma financial statements to estimate the impact of the adoption of the guidance. The pro-forma should be an educated guess as to the impact based on the assessment of the items above. Timing of the preparation of the pro-forma should be such that it allows the stakeholders to understand the implications, and for management to make the appropriate plans.
The pro-forma should be prepared such that it evaluates all potential transition methods and provides a basis for the company to decide on which transition method is most appropriate in the circumstances.
Communicate the impact assessment to stakeholders:
Once completed and if appropriate, during the preparation, management of the company should communicate the impact assessment to the board and audit committee, as well as the auditors. Significant assumptions should be understood by all parties, and in general, should be agreed to where possible and appropriate.
Implementation of the new guidance is complex and requires a significant amount of planning and upfront design work. The guidance may impact almost all companies and significantly changes the landscape around revenue recognition. An impact assessment is important to summarize the expected impact and plan for the implementation.
If you would like further information regarding our services on implementing the new revenue recognition standard, please contact us at: 310.477.3924, or at ENizzoli@SingerLewak.com