Earlier this year, the Financial Accounting Standards Board and International Accounting Standards Board issued substantially converged final standards on revenue recognition.
These standards provide a robust framework for addressing revenue-recognition issues and will replace almost all existing revenue recognition guidance, including industry-specific guidance, in current U.S. GAAP (hereinafter referred to as legacy GAAP).
Companies will have to dedicate significant resources to properly assess and implement these changes. If not properly managed in advance, this transition could be overwhelming for middle-market companies in particular, because they usually do not have the same level of resources that large companies have to assess and implement new accounting standards. While the guidance isn’t effective until 2017 for calendar year-end public entities and 2018 for all other calendar year-end entities, I think that companies – especially small-sized and mid-size entities – need to begin planning now for how they will implement the new standard.
The new revenue recognition model will bring monumental changes to how many companies account for and disclose revenue. Examples of significant changes to the timing and amount of revenue recognized by an entity that could result from the new guidance include those made to the accounting of the following.
In many cases, estimates of variable consideration that an entity ultimately expects to be entitled to, such as performance bonuses, should be recognized as revenue as soon as performance obligations are satisfied. This new guidance will often result in earlier recognition of variable consideration than recognition under much of legacy GAAP, which doesn’t generally recognize variable consideration until the contingency is resolved (that is, the performance bonus criteria are met).
Licenses of intellectual property (IP) must be analyzed to determine whether they provide a right to (a) use the entity’s IP (which generally results in recognizing revenue upon transfer of the right) or (b) have access to the entity’s IP (which generally results in recognizing revenue over time). One important consideration in making this determination is whether the customer has rights to any future changes to the IP.
Another is whether the rights to those changes represent a performance obligation that should be accounted for separately from the license. While there are some industry-specific revenue recognition models in legacy GAAP that provide guidance on how to account for licenses and rights to use specific types of IP such as software, motion pictures or franchises, these models are very different from the model in the new guidance.
The criteria used to determine whether an element should be treated separately are different in the new standard than they are under the general multiple-element arrangement models in legacy GAAP. To be accounted for separately under the latter, a delivered element must have stand-alone value to the customer. If the element is sold separately by the entity or another party, it is considered to have standalone value to the customer.
The analysis of whether a promised good or service is treated separately under the new guidance requires consideration of more factors than just whether the promised good or service is sold separately. They include the factor of whether the good or service is distinct within the context of the specific contract. The differing criteria in the new guidance could ultimately affect the timing of when revenue is recognized.
Under the new standard, an entity will be required to capitalize fulfillment costs and customer-acquisition costs if certain criteria are met. Capitalization of these types of costs for which there is no specific guidance in legacy GAAP generally depends on whether the costs meet the definition of an asset and whether the entity has made an accounting-policy election to capitalize such costs.
Under legacy GAAP, however, an entity is generally not required to capitalize such costs. The standard could result in a significant change if the entity does not already have an accounting policy that results in the capitalization of these costs.
Besides the changes noted above, the disclosure requirements in the new guidance will cause the volume of revenue-related information disclosed in the financial statements of companies to significantly increase, particularly for public entities.
Many new qualitative and quantitative interim and annual disclosure requirements are included in the new guidance. To be sure, there are some areas in legacy GAAP for which substantive revenue-related disclosures are required, such as accounting for multiple-element arrangements. But for most areas in legacy GAAP, the revenue-related disclosures are relatively limited. Significant effort will be required by companies to capture, track and aggregate the information that must be disclosed under the new guidance.
For change this significant, it’s never too early to start preparing. The introduction and implementation of a new comprehensive revenue recognition model brings a monumental shift to the way many companies account for revenue and disclose revenue-related information.
Both the timing and amount of revenue recognized could differ significantly and many new disclosures are required. Systems changes may also be required in many cases to capture and track information needed to apply the new model for accounting and disclosure purposes.
While the length of time until the effective dates provides some relief, it’s not too early for middle-market companies to start thinking about an assessment and implementation plan now.
Joe Adams is CEO and Managing Partner of McGladrey LLP, a leading provider of assurance, tax and consulting services focused on the middle market.