New Revenue Standard Could Bring Complex Changes

Businesses in the professional services and manufacturing sectors could see dramatic changes to their accounting policies if a new standard for recognizing revenue proceeds as proposed.

The proposed new standard, unveiled last month by the Financial Accounting Standards Board, would fundamentally revise the principles of revenue recognition for businesses with complex products that entail multiple performance obligations. Other businesses with more straightforward economic transactions (say, in the retail sector) would feel less of a bite.

Marshall

“It's going to depend on the company,” says Brian Marshall, a partner with auditing firm McGladrey & Pullen. “If you are a run-of-the-mill retailer, you’re probably not going to see that much of a change. But for certain companies and certain types of transactions, this could lead to huge change.”

FASB and the International Accounting Standards Board published the proposed new standard as part of their joint project to converge U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. FASB and IASB have pledged to complete that project by the end of 2011—a tight deadline that already has financial reporting executives anxious—and converging the standards for revenue recognition is a crucial piece of that task.

Revenue recognition under GAAP has long been criticized as complex and prescriptive, and the proposed new standard aims to replace more than 40 existing subtopics in the Accounting Standards Codification. In contrast, IFRS provides only two main standards addressing how companies should recognize revenue, with little guidance and lots of latitude on the specifics.

The new standard, proposed June 24, would instruct companies to recognize revenue when they transfer goods or services to a customer. Companies would be required to identify their performance obligations when they have contracts with customers, and then to tie the recognition of revenue to the satisfaction of those obligations.

Companies would also determine the amount of revenue to recognize by looking not only to the prices they charge their customers, but also the probability of collecting the full amount. Where the probability is less than 100 percent, the amount to be recognized would be prorated.

The real accounting indigestion starts when a company identifies more than one performance obligation under a given contract. When that’s the case, the company must allocate revenue to each individual performance obligation and recognize that revenue only as the obligation is met. Companies would also be required to take a hard look at who really controls an asset or a service, and recognize revenue related to it only after control over the good or service has been delivered.

According to Marshall, retailers that typically have clear-cut transactions with customers likely won’t see much change under the new rules. But service companies or those that manufacture complex assets under long-term contracts could see numerous challenges.

Doolittle

Such companies have long followed a revenue recognition method called “percentage of completion,” says Sam Doolittle, a partner with Deloitte & Touche. Under that idea, companies receive payment and recognize revenue in stages over the life of a long-term arrangement (construction projects, for example, or manufacture of ships or custom machinery). The percentage-of-completion method, however, will disappear under the new rules.

‘For certain companies and certain types of transactions, this could lead to huge change.’

—Brian Marshall,

Partner,

McGladrey & Pullen

“Under percentage of completion, you’re basically recognizing revenue all along the process of building something or completing something,” Doolittle says. Under the new rules, however, “you have to look at whether or not you are continuously delivering something to a customer or building something, then delivering a completed product to the customer.”

What It Means

Doolittle says companies that have operated under the percentage-of-completion method might take a close look at their contracts with customers and assure they transfer control, so that revenue won’t be deferred until the end of a long-term project. “I would expect there will be greater scrutiny on the importance of how contracts are struck with customers,” he says.

Triplett

Lynne Triplett, a partner with Grant Thornton, warns that applying the concept of “transferring control” to delivery of a service may not be easy. “A service isn’t an asset on a vendor’s balance sheet to begin with,” she says. “Generally, it’s someone's time or some other less tangible thing that is being transferred. It’s a little harder to see when that occurs.”

Peter Kyviakidis, managing director with consulting firm LECG, says the proposed standard is consistent with guidance FASB adopted last fall for how companies should recognize revenue for multiple-element products. Those are arrangements where a company might deliver a customer not only a physical product (say, a computer system), but also some add-on services (technical support and future upgrades).

REV-REC PROPOSAL BASICS

Essential Elements

This is a brief introduction to the

Exposure Draft, Revenue from

Contracts with Customers. It

provides an overview of the main

proposals that were developed

jointly and unanimously agreed

upon by the FASB and the

International Accounting Standards

Board (IASB).

The Exposure Draft contains

proposals on when to recognize

revenue, how to measure it, and

what to disclose. It also proposes

guidance to clarify the accounting

for some contract costs.

The proposals would be applied to

all contracts to provide goods or

services to customers, except for

leases, insurance contracts, and financial instruments.

The core principle of the proposed

standard is that a company should

recognize revenue when it transfers

goods or services to a customer in

the amount of consideration the

company expects to receive from

the customer.

Project Process Stage

In June 2010, FASB and

IASB (the Boards) issued the

Exposure Draft which is the result

of extensive discussions of the

Boards and reflects input received

from preparers, auditors, investors,

regulators and other interested

parties.

The Boards invite all interested

parties to comment on the Exposure

Draft as part of their rigorous due

process.

During the comment period, they

intend to undertake various outreach

activities (e.g. Webcasts, roundtable

meetings, and field visits) to discuss

the proposals with a wide range of

interested parties.

The Boards intend to carefully

consider all feedback, redeliberate

significant issues, and issue a final

revenue standard in 2011.

The Exposure Draft is open for public

comment until October 22, 2010.

Comment Deadline

The Exposure Draft is open for public comment until Oct. 22, 2010.

Source

FASB (June 2010).

Previously, companies could not recognize revenue in chunks over time for such arrangements unless they had clear evidence of how each element would be priced. Under FASB’s new guidance from last fall, companies now have more room to estimate prices where objective evidence of pricing isn’t available. The proposal for revenue recognition is essentially the same concept applied on a larger scale.

Kyviakidis

In that respect, Kyviakidis says, anyone who has begun using last year’s guidance is already moving down the path of the proposed new standard. “They should be very well along the path of achieving this new approach based on the guidance that came out earlier,” he says.

The provisions about collecting revenue are another significant departure from current practice, Kyviakidis adds. Under existing guidance, if collection of revenue was not reasonably certain, a company could not recognize that revenue until it actually was collected or collection was assured. But under the new standard, “if I make an assessment of how much of the sales price is going to be reasonably collectable, and say it’s 75 percent, then I recognize that portion. Before I had to defer all of it.”

That will lead to accelerated recognition in some cases, Kyviakidis says—but also to more judgment as well. Because the proposal calls for the use of judgments and of estimates according to principles rather than prescriptive rules, it is bound to present some challenge, Triplett adds.

The standard will call for plenty of disclosure around how judgments and estimates enter into the numbers that will appear in financial statements, Triplett says. However, that subjectivity could lead to some differences in how companies time the recognition of revenue.

“At the end, you’ve earned a number, and that’s the revenue,” she says. “But along the way, there will be some opportunity for management to say what that revenue would be based on changes in estimates.”

FASB and IASB are accepting comments on the proposals through Oct. 22. The boards are also conducting Webcasts and planning roundtable sessions to explain and solicit feedback before finalizing the standard.

While the standard is targeted for completion in early 2011, an effective date has not been determined. FASB and IASB plan to consider the effective date in the context of several major standards that are due to be completed all at the same time as part of their convergence plan.