Welcome back, all you eager readers! I know you’ve been awaiting this like the world awaited the final season of Game of Thrones. So here it is, Episode 2 of the three-part mini-series on Revenue Recognition (a.k.a. Everything You Always Wanted to Know About Rev Rec). Ready to get technical?
Last time, we went over the “why” of the new revenue recognition standards. Now, we’re going to discuss the “what,” as in what are the changes. And next time, we’ll get to the “how,” meaning how to implement them. First, we need to do some requisite citing of the standards, and define a few things.
The Core Principle(s) and Other Definitions
The core principle behind the new Rev Rec standard is: An entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the reporting entity expects to be entitled in exchange for those goods or services.
You might ask, ‘How is this different from what we’re doing now?’ Under the old GAAP rules, revenue generally is considered earned, and either realized or realizable, when these four criteria are met:
- Persuasive evidence of an arrangement exists
- Delivery has occurred or services have been rendered
- The seller’s price to the buyer is fixed or determinable
- Collectability is reasonably assured
Under the new rules, this has all been replaced with the following two principles:
- WHEN to recognize it—The concept of transferring promised goods or services to customers is essential to the timing of revenue recognition.
- HOW MUCH to recognize—The concept of consideration to which the entity expects to be entitled is essential to the measurement of recognized revenue.
These new principles are applicable for anyone who enters into a contract with customers. First, it’s important to understand what a contractand customeractually mean, so let’s define:
- Contract: any agreement between two or more parties that creates enforceable rights and obligations, whether written, verbal or implied.
- Customer: a party that has contracted with a company to obtain goods or services that are an output of the company’s ordinary activities.
Whew! Glad that’s over. In the next part of this series, we’ll cover a five-step process on how to implement all of the above principles above – more to come on that. But first, let’s go over what everyone is wondering, ‘What’sreally going to change?’
The Times They are a-Changin
Bob Dylan couldn’t have been more right about that! While change is a given, the effect on day-to-day recording of sales will vary depending on the company’s type of revenue, and it will affect every company that issues financial statements.
One thing that will definitely change for all companies is what is required to be disclosed in the footnotesto financial statements. In the spirit of transparency, the footnotes will be required to show both quantitative and qualitative information. Most of my clients have a paragraph describing their company’s accounting principle for when they recognize revenue, and it’s a paragraph of three or four lines, often only two sentences. Sorry to say this, but bid farewell to simplicity.
Transparency and Greater Detail
After companies implement Rev Rec, they will need to assess what information would be useful to readers of the financial statements. As noted above, this is in the spirit of transparency, which means removing any confusion, full-disclosure, etc. Thus, the requirements are not super specific, and instead leave management to think about what satisfies the disclosure objectives, the amount of emphasis to place on different parts of the disclosure, and how to present it so that it is clear for the reader. In other words, they don’t tell you exactly what to put in your financials, so you have to think about what the reader needs to make it most transparent and most useful.
One of the biggest changes in the disclosures is the requirement to show disaggregated revenue, which means revenue at a level below the financial statements, i.e. a descriptive summary that includes more pieces of the pie. Examples could include: type of goods or services; geography (such as sales by state); market or type of customer (like government versus non-government); or product lines or sales divisions. For many companies, especially those with simpler accounting systems, this may require tracking of sales at a greater level of detail.
As you may have noticed, the standard is really all about contracts, and accordingly, Rev Rec from contracts is required to be disclosed separately from other sources of revenue. Opening and closing balances of receivables from contract revenue are also required, including explanations of the changes (business combinations, impairments, changes in contract timeframes, impairment losses, etc.).
Performance obligations also have some requirements for disclosure. Companies must identify what it means to satisfy these performance obligations, such as “upon delivery” or “as services are rendered.” They must also identify significant payments terms, obligations for returns, refunds, and the like, as well as types of warranties or other such obligations.
Also required are disclosures on significant accounting judgments (since they can vary company to company), including those related to defining the transaction price, and determining the timing of satisfaction of the performance obligations. See what I mean about transparency?
Before We Sign Off
I’d like to add a very important caveat to all of this: non-public companies have MUCH more flexibility in what they are required to disclosethan the publicly-traded companies.
I also encourage all those in management of their respective companies to discuss with their accountants what all the options are, and what other comparable companies are doing. Don’t have an accounting firm with whom you work yet? Give us a call, and we’d be happy to have a sit-down meeting and discuss.
Stay tuned for the next episode that will present the five-step process on “how” to implement the new Rev Rec standards. Are you excited? I’m stoked!!