At the recent AICPA SEC and PCAOB Developments Conference, James Shnurr, SEC Chief Accountant, noted that preparers have lots of questions about accounting for transactions under the new standard and they need answers in order to implement the standard. If those answers require additional rule making this might cause a delay in the effective date of the standard. He also pointed out that comparability was a hallmark of the standard setting process. You can find more on his comments this Journal of Accountancy article.
In addition to the FASB/IASB Transition Resource Group which is looking at 28 issues and counting, the AICPA is trying to aid comparability through 16 industry focused task forces to assist in understanding the standard and provide examples. These task forces have been hard at work, but are just now coming to the point of sending information up to the AICPA Finance Reporting Executive Committee for review with publication of results not expected to happen any time soon. If comparability is a real key, I think it behooves the FASB to consider a delay to allow these groups to positively impact comparability within each industry as a result of their work.
The FASB is in the middle of outreach to understand where preparers are in implementing the standard and the issues they are encountering. They are considering a possible delay in the standard based on what they find during the research. The FASB has been clear that simply not getting around to the work is not a reason for a delay. Instead, they are looking for real substantive issues preparers are having with implementing the standard in time for a retrospective application. Either way, we should hear from the FASB in the first half of 2015 about a potential delay. Interestingly the IASB is saying they are not hearing any requests for a delay in the standard, but this is probably greatly influenced by the fact that under IFRS you only have to provide two years of income statements rather than three as required by the SEC. If US preparers only had to provide restated income statements for 2016 and 2017 and not 2015, I think you would be hearing a lot less about the need for a delay.
There is so much going on with the revenue standard I can’t possibly cover it all here. Bottom line is that the issuance of the final standard wasn’t the end, but really was only the end of the beginning of the process of changing the accounting for what is the most important number in the financial statements.
In this blog on the revenue recognition standard I want to cover how you determine the allocation of revenue across performance obligations. As I mentioned in previous blogs performance obligation is the new term for deliverable and it includes items that previously were not considered standalone deliverables. Once you determine your performance obligations and total compensation due from the customer (known as Total Transaction Price or TTP), you have to allocate that TTP over the performance obligations.
As a reminder, today we allocate the total compensation over the deliverables using a relative standalone selling prices for each deliverable. If you are getting paid $80 for two deliverables each with a standalone selling price of $50 then you allocate $40 of revenue to each deliverable ($50/($50+$50)*$80). The allocation process under the new standard is the same but the difference comes in how you determine standalone selling price (SSP). Today we have a strict hierarchy we must follow:
- If Vendor Specific Objective Evidence (VSOE) – or what you sell the product for on a standalone basis – is available we must use that to determine the standalone selling price
- If VSOE is not available then we look at Third Party Evidence (TPE) – or what someone else sells the product for on a standalone basis
- If VSOE or TPE does not exist then we use our best estimate of the selling price
The new revenue standard does not include the above strict hierarchy for determining standalone selling price. It does say the best evidence is an observable price when the entity sells the good or service separately, but then it goes on to add “in similar circumstance and to similar customers.” If I have been selling a product in California and launch a new operation in Texas I can probably reasonable argue that the sales price in California is not in a similar circumstance to a similar customer so I do not need to use it to determine the standalone selling price in Texas. The same might also be said for selling a single cellphone to a customer versus a multiple line plan because it can be argued a multi-line customer is not “similar” to a single-line customer.
The new standard goes on to say that if a standalone selling price is not directly observable you need to estimate the SSP by “considering:”
- Market conditions (I take this to mean TPE)
- Entity-specific factors (I don’t think this is VSOE, but your guess is as good as mine)
- Information about the customer
It goes on list ways to estimate a standalone selling price including bringing back the residual approach as a last resort which was eliminated from GAAP a few years back.
When a deliverable today equals a performance obligation tomorrow, I think many companies will initially default to the standalone selling price they already use today. As new products and services are developed and new performance obligations are added that don’t exist as deliverables today, I predict you will see a decline in the use of VSOE.
Another significant change in revenue recognition in the New Revenue Standard is the change in the way sales incentives are handled. Under current GAAP, unless you as the vendor are also a customer of your customer and paying for something in that capacity as a customer, any cash or a cash equivalent such as a bill credit or a gift card redeemable from you is considered a sales incentive that is recorded as contra-revenue. On the other hand if you give the customer an item you do not sell in the ordinary course of business such as bank giving away a free toaster for opening up an account, a wireless service provider giving away iTunes gift cards or a credit card company giving away loyalty points that can be redeemed for airline tickets or other merchandise, those items are still sales incentives, but are recorded as expense.
The new standard changes the accounting for sales incentives. Cash or cash equivalent sales incentives are still recorded as contra-revenue, and the cost of non-cash equivalent sales incentives is still expensed, but under the new standard the non-cash sales incentives are now considered a distinct performance obligation that must have a portion of the revenue from the contract – known as the Total Transaction Price (TTP) – allocated to them. The portion allocated to the non-cash sales incentive is recognized as revenue when the performance obligation is satisfied.
In the case of a service company giving away a different company’s gift card for signing a two year service agreement that means a portion of the revenue will be recognized as soon as that gift card is delivered which will generally mean earlier revenue recognition than under today’s rules. In the case of loyalty programs where points are earned and merchandise is usually delivered (long) after the transaction that resulted in the award of loyalty points, revenue will be recognized (significantly) later than under today’s rules.
No matter which way your company’s revenues are impacted, the one thing that is clear is that change is coming and it will be incumbent on preparers to be able to crisply outline how and why revenue is changing under the new standard to investors, internal management and really everyone in your company.
Probably the second most significant change under the new revenue recognition standard is the requirement to defer incremental costs to obtain a contract and costs (notice the word incremental is not listed here) to fulfill a contract. This change, like many of the most significant changes, impacts service and technology companies more than traditional manufacturers. Under current rules, companies have options when it comes to these costs and most companies chose to only defer such costs up to the amount of any upfront activation fees deferred under today’s revenue rules. Some companies make an accounting policy election to defer additional upfront costs over the life of the customer contract. Those companies will likely see less impact from the new requirement with changes mainly coming from aligning the costs being deferred to the new definitions.
Companies that defer upfront costs today, however, are in the minority. In fact, the irony of the Boards’ position on these costs is that over the last two decades many companies have moved from deferring all upfront costs to only deferring costs up to the amount of deferred revenue, and they received “preferability” opinions in the process of making that accounting policy change. I guess the fact that the accounting firms issued and the SEC accepted those opinions carried little weight with the Boards when it came to their effort to revise the matching of revenue and expense.
Companies are going to need to set up new processes and systems to accumulate and account for such costs. Today, many companies simply look at qualifying costs overall, stop counting when they get to the amount of deferred revenue, and simply book an entry deferring the same amount of cost as they have deferred for revenue. They also use the revenue amortization schedule to amortize the deferred costs. This process results in no need to look at all possible costs and allows the procurement and payable systems to book expenses straight to the general ledger without the need to additional sub ledgers or systems.
Under the new rules, that process won’t be so simple any more. Companies will need to evaluate costs to determine if they are incremental costs to obtain a contract (probably fairly obvious) or upfront costs, such as setting up a customer in your system or connecting them to your service (that include labor and other less obvious and easily isolated costs). Once they have determined the costs to be deferred, amortization schedules will need to be set up and the costs will need to be evaluated for impairment on an ongoing basis.
It is hard to disagree that the proposed process does a better job matching expense to the recognition of the related revenue. The problem is that the better job comes at the cost of a much more difficult accounting process that is also less conservative.
The FASB and IASB issued their converged revenue recognition standard on Wednesday, May 28. The 700 page document can be found here (ASC 606, Other ASC Conforming Changes, Basis for Conclusions and Implementation Guidance). While the standard is not effective until 2017, there is no time to wait to begin your implementation work on this one. If you are at a public company planning a retrospective approach you have just 7 months until you need to start computing those “prior year” amounts for your 2017 financials. You have an extra year if you are a private company and only have to report one year of comparative income statement amounts, but if you enter into long-term contracts you may already be past the time when you need to start gathering information for changes to your revenue recognition related to those contracts.
The new revenue recognition standard may be the most significant change to accounting standards in the 40 year history of the FASB. The exact impact depends on the type of business on which you report. Software, telecom and technology in general are likely to see the most significant impacts, but every type of business is likely to see some level of changes which will require new processes, new controls and possibly new accounting systems. You can see more about the changes in a Journal of Accountancy Article here. If you want to hear more about the telecom industry impact you can listen to a podcast interview of me by JOA editor Ken Tysac here.
The most significant changes in the revenue recognition standard are:
- Elimination of the contingent (cash) cap on recognizing revenue
- Deferral of all costs to obtain and fulfill a contract – this is no longer a policy election (where upfront recognition was considered “better” accounting – how ironic) and the deferral can no longer limited to the amount of revenue that you deferred
- Sales incentives that used to be considered an expense are now considered a (separate) performance obligation and must have revenue allocated to that obligation.
- Change in the hierarchy of support for “stand-alone selling price” (SSP) and the return, in some cases, of the residual method for computing SSP
I will cover each of these changes in more detail in future blogs, but in summary this standard will likely require earlier recognition of revenue and later recognition of expenses than currently allowed in GAAP. Whether that is good or bad is up to you.