New Revenue Recognition Rules
The new accounting standard for revenue recognition will likely affect every aspect of a business that relates to revenue, from a company’s financial results and compliance with debt covenants to executive compensation. Yet surveys show that many companies are dragging their feet and have yet to begin preparing for this impending change, which means some may be dangerously behind.
Although the first financial reports that will be required to use the new revenue recognition standard are still more than a year off, for many companies the reporting periods that are subject to the new standard are already underway. Also, many organizations that have started to implement the required changes are finding the process to be much more complex and time-consuming than they expected — with implications that go far beyond accounting. This is sobering news for companies that are procrastinating in the hope of pulling off a last-minute miracle.
Here are five key areas that companies will need to address as they implement the new revenue recognition standard.
Accounting. The new standard specifically focuses on how companies recognize revenue associated with customer contracts. In the past, there was wide variation in how revenue was recognized — particularly among different industries and geographies. The new standard, which was jointly developed by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), provides a globally consistent framework that strives to recognize revenue more consistently, both in terms of timing and earned monetary value.
To achieve its goal, the new standard relies much more heavily on estimates and judgments. This in turn requires additional data gathering and reporting, including extensive disclosures — not only about the data used, but also about the judgments that were applied when producing the estimates.
Revising a company’s accounting processes and controls to support this new approach is a significant undertaking that could take much longer than a CFO might think – and along the way the CFO should consult with the company’s auditors, as well as, when appropriate, FASB, IASB, and the SEC.
IT systems. Compliance with the new revenue recognition standard will almost certainly require data that is not currently being collected, aggregated, or reported.
For example, many existing IT systems were not designed to capture material rights as performance obligations, which is a requirement under the new revenue recognition standard. Similarly, many IT systems do not currently capture and track the start and end dates for contracts, which is now required. Also, many data elements in contracts are text fields that make it difficult for companies to extract the specific information needed to automate certain revenue recognition processes.
Designing, developing, and testing the necessary system modifications could take many months to complete, especially since it will generally require custom software development — not just installation of a standard update.
System changes of this nature cannot be thrown together at the eleventh hour, which is one of the key reasons it is so important to get started right away.
Legal (contracts). The new revenue recognition standard assumes that customer contracts will contain certain elements — including specific provisions for termination, pricing, and enforcement — that might be handled differently (or might not be present at all) in a company’s existing contracts.
A company’s legal department will need to study the new standard and adjust its typical contract terms accordingly. Also, it will need to analyze existing contracts to determine if there are cases where the current contract terms are likely to have an undesirable impact on revenue when the new standards are applied. In such cases, a company might choose to revise the contracts in order to avoid those undesirable impacts. However, if customers also have to run everything past their own lawyers, the process of revising existing contracts can be both drawn-out and contentious.
HR (staffing and training). Implementation of the new standard is a major undertaking that will likely require significant resources and staff. In addition, it will likely require extensive training, not only for the accountants who need to apply the new standard but for anyone involved in negotiating and reviewing customer contracts. That includes sales people, sales managers, the legal department, investor relations, and executive leadership.
Compensation. The new standard affects the timing of when revenue is recognized. That can have a big impact on executive bonuses, sales commissions, and any form of compensation linked to revenue-related metrics, including broad metrics such as profitability and EBITDA.
To address the potential impact for existing compensation programs, there are two basic choices. A company can either redesign the detailed terms of the program to try and replicate the payouts that would have occurred under the old revenue recognition standard, or it can maintain separate records that recognize revenue the old way for compensation purposes.
The first option may require considerable time and effort, and legally may require approval from all affected stakeholders, which can be difficult to obtain. The second option is theoretically more straightforward, but requires ongoing duplication of effort. Even then, the second option could be vulnerable to legal challenges, since the unofficial, old-style numbers likely won’t carry quite the same legal weight as official numbers.
Full or Modified?
One of the biggest issues companies must address when deciding how to implement the new standard is whether to use the “full retrospective” transition method or the “modified retrospective” transition method. With the “full retrospective” method, financial results for the current year and two prior years are all presented using the new revenue recognition standard. With the “modified retrospective” option, only the current year is presented using the new standard, while the two prior years are presented using the old standard accompanied by disclosures that explain how to compare the new with the old.
At first, many companies were leaning toward the modified option because it seemed like a lot less work — even though it would likely be harder for analysts and other financial statement users to interpret and compare the results. However, momentum now appears to be shifting toward the full option as companies consider the needs of analysts. Also, in practice the difference in effort between the two options is often not nearly as large as it might seem, since the bulk of the implementation work goes into core activities such as modifying systems, processes, contracts, and compensation programs — work that is essentially the same for both options.
By the way, for companies that end up choosing the full retrospective option, it’s even more important to start right away because under that option the revenue being captured today is already subject to reporting using the new standard.
If your company is already working to implement the new standard, congratulations — you are ahead of the pack and just need to stay focused and maintain momentum. On the other hand, if your company is still sitting on the sidelines, it’s time to get in the game.
The first step — and most crucial — is to create a cross-functional project team with expertise in accounting, information technology, legal, sales, processes, and controls. All of those are needed to develop an implementation strategy and methods that can achieve compliance with the standard.
The next step is to identify and analyze all of a company’s revenue streams, examining a sample of contracts for each stream to uncover trouble spots and inconsistencies with the new standard. This step is extremely important and needs to happen sooner rather than later, because digging into the details of specific contracts is the only way to get a real feel for the magnitude of the challenge. A back-of-the-envelope assessment just isn’t good enough.
Many companies that have already started down the implementation path are finding the challenge and complexity of complying with the new revenue recognition standard to be much greater than they expected. Getting started now is the best way to mitigate the stress and headache of a last-minute fire drill — or even worse, the unthinkable outcome of not being able to issue compliant financial statements once the new standard goes into full effect.
Eric Knachel is a senior consultation partner in Deloitte & Touche LLP’s national office accounting services in Stamford, Conn.
Republished from CFO.com