Companies renegotiating long-term contracts with customers would be wise to check with their auditors about how to recognize revenue under the old agreement. They may be surprised by what they hear.
Market downturns inspire vendors and customers in virtually any sector to review the economics behind existing service or supply contracts, says James DePonte, a partner with PricewaterhouseCoopers. “Sometimes they were negotiated in stable or heady times,” he says. “It’s not uncommon for underlying markets for those products to have fallen through the floor.”
That pushes customers to wrangle for price breaks on long-term supply arrangements in any number of industries, he says. “It could be something as simple as a publisher buying paper,” he says. “Commodity markets tend to go crazy in a market like this.”
So how does revenue recognition complicate the picture? Start with the basics: Accounting rules tend to link the recognition of revenue with the act of providing a product or a service, not with the receipt of cash, DePonte says. Companies generally recognize revenue not when they get a check in the mail, but when they ship a product or fulfill a service obligation.
In the case of a long-term contract, even if a company receives an upfront payment at the start of an agreement, that payment doesn’t immediately appear in financial statements as revenue; companies recognize it in chunks over time, as they ship products or provide services throughout the life of the contract. Companies tend to assume that as an old contract ends and a new one begins, they should book any unrecognized revenue under the old contract and start accounting for the new one from day one, as if the slate had been wiped clean.
Triplett
Not so, warns Lynne Triplett, a partner with Grant Thornton.
“In almost every situation you have to look at those contracts together,” she says. “That’s the form the negotiations took. You’ve effectively changed the terms of an ongoing relationship.”
The distinction between terminating a contract and modifying it is important for accounting purposes, because that affects how the company will recognize revenue associated with the old arrangement, DePonte says. Companies may assume they should recognize revenue immediately on any lump sum they receive to settle an old contract, or on any earlier payment they received that hasn’t yet been recognized. But, in fact, they may need to fold any such amounts into the new contract and recognize them over the life of the new agreement.
“Revenue is all about recognizing things when a product or service has been provided,” DePonte says. “The receipt of cash in connection with a renegotiated contract wouldn’t necessarily trigger revenue recognition.”
Howell
Jay Howell, a partner with BDO Seidman, says the question increasingly comes up in the technology sector, where companies routinely establish complex, long-term product-and-service contracts, sometimes even involving multiple parties. “It’s not uncommon for the customer’s needs to change over the life of the contract,” he says.
“The receipt of cash in connection with a renegotiated contract wouldn’t necessarily trigger revenue recognition.”
—James DePonte,
Partner,
PricewaterhouseCoopers
Whether the parties agree to modify the original contract, or simply tie off the old agreement and write an entirely new one, the substance of the change trumps the form of it in deciding when and how to recognize revenue, Howell says. “The objective is to assess whether the modification or termination was economically linked with the new arrangement,” he says. “If so, my view is the accounting standards would require the two arrangements to be assessed together.”
DePonte said preparers often reason that the individual legal contracts are distinct from one another, so they should be recognized as such. Preparers wonder if “I have no further obligation under the old contract, I received cash payment, and it’s non-refundable, why isn’t this revenue?” DePonte says. “In my experience, auditors and regulators will take a more holistic view. If you have a continuing relationship, we tend to look at it more holistically as opposed to one contract or another.”
Howell says uncertainty and tension often exist over how to handle revenue recognition because the accounting literature isn’t explicit and guidance has sprung up over the years from multiple sources: the Financial Accounting Standards Board primarily, but also the Securities and Exchange Commission and the American Institute of Certified Public Accountants. Revenue recognition has been described as one of the more complex areas of Generally Accepted Accounting Principles, particularly as industry-specific guidance emerged to address some of the nuances of complex business contracts.
Marshall
Brian Marshall, a partner at McGladrey & Pullen, says the essential guidance today is found in the Accounting Standards Codification under Topic 605, Revenue. It encompasses FASB accounting standards as well as guidance originally issued by the SEC as Staff Accounting Topic No. 13 and AICPA technical practice aids originally specific to the software industry.
CONTRACT RENOGIATIONS
Below is an excerpt from PwC’s March 12 newsletter warning about revenue pitfalls when renegotiating old contracts:
Over the last 18 months the unstable economic environment has, in some instances, reduced the demand or changed the market pricing for certain products or services so drastically that existing long term supply arrangements, such as take or pay arrangements or fixed price contracts, may now be significantly unfavorable to one or both parties.
Some companies have been able to renegotiate these contracts—which can trigger a variety of revenue recognition questions. For example, renegotiated arrangements often include a one-time payment to modify current contract terms or to terminate the previous arrangement. If the cash payment was not contractually due under the terms of the original contract, then generally this one-time payment would be recognized over the term of the new or modified contract (i.e., treated as an upfront fee related to the new arrangement as opposed to a termination payment for the old arrangement).
Alternatively, other arrangements may have a lump-sum cash payment at the initiation of the arrangement that is currently being recognized over the length of the arrangement or customer relationship period depending on the facts and circumstances (i.e., being recognized over the period of the customer’s expected benefit received from that payment). If that arrangement is subsequently terminated and a new arrangement entered into (presumably with different terms), that benefit to the customer may extend through the renegotiated contract period, and therefore the unrecognized revenue associated with that initial up-front payment should be recognized over the life of the new contract.
Source
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align="left">PricewaterhouseCoopers (March 12, 2010).
Triplett says companies need to consider carefully how they would account for any concession they might make to customers as part of a change in contract terms. “If the vendor is sitting on the unfavorable side of the relationship and makes some sort of concession or refund, that’s a reduction of revenue,” Triplett says. Companies and their auditors would have to look carefully at the situation to determine how to account for it, she says.
Marshall said companies should also be aware of the cascading accounting implications of making concessions—not only for the contract in question, but also for the rest of their accounting. Generally, revenue recognition rules require companies to point to a fixed or determinable fee and its collectability if they want book revenue before payment is received.
“If you develop a pattern of entering into an arrangement, then modifying it or making concessions, that could call into question whether in the future you’re meeting the revenue recognition criteria for a fixed, determinable fee,” Marshall explains. If companies fail to clear that hurdle, they may be prevented from recognizing revenue on other arrangements when they deliver the goods or services. Instead, they may have to wait to recognize revenue until they receive payment.
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