The Bottom Line: Changes to Revenue Recognition Requirements
Once effective, the ASC 606 standard will replace about 180 pieces of industry and transaction-specific rules under U.S. Generally Accepted Accounting Principles.
Quinn R. Martin, CPA, CMP, MBA, Mueller Prost
Revenue is considered one of the most important financial statement measures. It is used to assess a company’s past financial performance, future growth potential and financial well-being. This makes revenue recognition one of the accounting topics most scrutinized by business owners. The Accounting Standards Codification (ASC) 606 standard, Revenue from Contracts with Customers, which could take effect as early as this December, could result in different accounting for similar transactions.
The standard, once effective (see chart), will eliminate many existing revenue standards and replace about 180 pieces of industry and transaction-specific rules under U.S. Generally Accepted Accounting Principles (GAAP). The objective of the revenue standard is to provide a single, comprehensive revenue recognition model for all contracts with customers to improve comparability within industries, across industries and across capital markets.
Once the new standard takes effect, mold builders will apply the same standards for revenue recognition as those in similar and dissimilar industries. That is, the same standard for revenue recognition will be applied from everything from the sale of a mold to the production of a plastic part to a bakers’ contract to produce cookies for a local retailer.
The Core Principle
The core principle of the new standard is that a company would recognize revenue as it transfers goods or services (tools or design services) to customers in an amount reflecting the consideration (the price outlined in the customer contract or purchase order) it expects to receive, as opposed to recognizing revenue when the risks and rewards transfer to the customer under the existing revenue standards. To achieve this core principle, tool builders will follow these five steps:
1. Identify the contract(s) with the customer (purchase orders, change orders or customer contracts).
2. Identify the separate performance obligations contained in a contract. A performance obligation is a promise to a customer to transfer a good or service. For mold builders, these will be the functionality and performance specifications outlined in the purchase order or agreement.
3. Determine the transaction price of the contract. The transaction price is the amount of consideration that a vendor expects to be entitled to in exchange for the goods or services. This will often be the amount specified in the contract or purchase order, but not always.
4. Allocate the transaction price to separate performance obligations. If multiple performance obligations are identified in the contract or purchase order, the amount allocated to each separate performance obligation would be the amount of consideration which the mold builder expects to receive for meeting the milestones outline in the agreement with the customer.
5. Recognize revenue when (or as) each performance obligation is satisfied. That is, revenue is recognized as performance obligations are met.
Transitioning and Reporting Requirements
The ASC 606 revenue standard includes extensive disclosure requirements intended to enable users of financial statements to understand the amount, timing, risks and judgments related to revenue recognition and related cash flows. For example, it requires disclosure of both qualitative and quantitative information about contracts with customers. Basically, a narrative and amounts explaining how revenue is recognized. And, for U.S. GAAP only, provides some simplified disclosure options for nonpublic entities. That is, companies must disclose the methodology they used to determine the proper amount of revenue to be recognized.
Mold builders may retrospectively apply the new revenue standard or use a simplified method that provides for certain practical expedients. The retrospective transition method of ASC 606 requires all reporting periods presented in the financial statements to be reported under the new guidance, and the mold builder is required to disclose any prior-period information that was adjusted.
The alternative transition method requires a company to apply the new standard only to contracts not completed under legacy GAAP at the date of initial application and recognize the cumulative effect (the change) of adoption as an adjustment to the opening balance of retained earnings in the year of initial application. A company choosing to apply the alternative transition method would not restate comparative years, but it would be required to provide additional disclosures in the initial year of adoption. That is, mold builders will be required to disclose the difference in revenue recognized using the old standard and the new standard.
These changes in revenue recognition may present challenges for mold-building companies, such as bundled goods and services (design services or warrants bundled with the sale of a mold), transaction price calculations for multiple tools or services, contract considerations (contract combinations and modifications), capitalization of costs to acquire customer contracts, financial statement disclosures and tax implications.
To overcome these challenges, mold builders may need to implement new policies; adopt updated or new ERP, accounting or general ledger systems; use new processes and controls; provide effective training and communication of new requirements for both staff and external users (such as banks); and offer a structured means of implementing the new revenue recognition standard.
Some effective first steps to evaluating the implications of this new standard may include:
• Evaluating significant revenue streams and key contracts to identify the specific revenue recognition changes required and the specific business units where these changes may have the greatest impact.
• Addressing the longer lead time areas where new or revised allocation processes may be required.
• Establishing a detailed project plan and roadmap to manage the effort across multiple business units.
A cross-functional team with expertise in various disciplines, such as accounting, information technology, legal, sales and manufacturing, is recommended to ease the process.
The next step is to identify and analyze all a company’s revenue streams, examining several sample contracts for each revenue stream to reveal potential problems and inconsistencies with the new standard. This step is extremely important and needs to happen very soon, because digging into the details of specific contracts and purchase orders is the only way to assess the magnitude of the challenge. A quick overview assessment will be insufficient.
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.
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