The Hidden Cost of the New Revenue Recognition Standard
The Financial Accounting Standards Board (FASB)’s Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), applies to all contracts with customers unless the contract is within the scope of another standard (e.g., leases, insurance, financial instruments). The standard became effective for public companies for the first interim period beginning after Dec. 15, 2017, and nonpublic companies in the years beginning after Dec. 15, 2018. Businesses can apply this ASU retrospectively, or they can elect to recognize the cumulative effect of applying the new standard to existing contracts in the opening balance of retained earnings on the effective date (with proper disclosures).
This ASU will significantly affect the current revenue recognition practices of most companies. It could also impact the timing and amount of revenue reported, key performance indicators, debt covenant ratios, bond programs, contract negotiations, performance agreements, business activities and budgets. It is therefore important to look at the capitalization of costs associated with deferred revenue and its impact on the balance sheet.
The ASU requires that revenue is recognized when the good or service is transferred or as control over the good or service is transferred. Therefore, revenue can be recognized over time (services) or at a point in time (goods).
Recognizing revenue over time is like the percentage of completion method of accounting with a slight adjustment. One of the following two conditions must be met to recognize revenue incrementally:
- The customer must have control of the asset as it is built or improved, or
- The asset must have no use to you; therefore, you have right to the payment.
Recognizing revenue at a point in time involves recording revenue for each performance obligation as it is completed or when the customer takes control of the asset. Control of the good or service is defined as “when the customer has the ability to direct the use of or can benefit from the transferred good or service.”
The timing of contract-related costs will have a significant impact on a company’s balance sheet as well. These include the cost to obtain and fulfill the contract.
CPAs need to analyze how this ASU will affect balance sheets. There could be a major impact on how contract accounts are organized and the presentation of contract-related assets and liabilities on the balance sheet.
Commission and earnout agreements may need to be revised. Under the ASU, commissions that are directly attributed to a specific contract are treated as acquisition costs. These costs will need to be capitalized and amortized over the contract’s life. This may cause a change in the timing of commission payouts. Earnout agreements that extend beyond the ASU’s effective date will typically have to be adjusted due to a change in when contract-related expenses will be recognized.
Businesses are required to maintain the financial metrics outlined in the terms of a loan or bond agreement. This can include everything from minimum working capital ratio to maximum debt-to-equity ratio requirements. Lenders and sureties use this information to determine if the company is financially healthy.
Since ratios may be negatively impacted by an increase in liabilities on the balance sheet, it is important for companies to have a conversation with their banker and surety to explain why. Develop a pro forma of what the balance sheet will look like once revenue is recognized in compliance with this ASU.
The costs related to implementing this ASU reach far beyond changes to internal processes and procedures. Businesses should develop scenarios based on typical situations and thoroughly analyze the possible impacts. It is always better to be safe than sorry.
This article appeared in the May/June 2019 issue of New Jersey CPA magazine. Read the full issue.