Accounting Disruption — Part I: The Revenue Recognition Standard
How often do you hear accounting and disruption in the same sentence? Debits, credits and financial statements don’t exactly lead anyone to think of radical change. Yet, that’s exactly what is about to happen seven months from now when the new revenue recognition statement, first issued jointly by the Financial Accounting Standards Board and International Accounting Standards Board (“FASB” and “IASB”) in May 2014, becomes effective on January 1, 2018. And make no mistake about — it’s a disruptor.
I don’t use the word disruption often, because quite frankly it’s overused, but it is right on point with FASB this time. To me, disruption is more than automation, or using sophisticated software, or a gain of efficiencies. True disruption is nothing less than a total overhaul of the existing business model that brings pervasive changes to all aspects of the business. In the context of accounting, it means a change that necessitates a re-thinking and re-working of the way items are measured and reported as well the policies and procedures within the company and its relationship with customers and vendors. The new revenue recognition statement does just that.
What it means
It is pervasive because revenue is essential for any business to exist, and because revenue affects every process and relationship within and outside of the business. Sales to customers, cloud-based platforms, stock-based compensation, supplies, fixed assets, and on and on…. The impact of this new standard, therefore, goes far beyond the accounting and financial reporting department and will affect business processes, IT, taxes, investor relations, human resources and compliance.
It will absolutely require a re-thinking and re-working of the way revenue is measured and reported because it completely upends the existing risk/reward framework and introduces a new concept of transfer of control. How revenue will be reported beginning next January will look nothing like what it does now.
It will require businesses to develop new policies and procedures to account for performance under all of the contracts that exist and that will be entered into the future using a new unit of measurement — performance obligation. Under this concept, revenue is matched to the passage of control. This means that some of the revenue that is being currently recognized entirely at a point in time, may have to be recognized in stages.
As it goes with FASB statements, there is concrete guidance plus a lot of room for estimates and interpretation. That’s a good combination to keep technical accounting departments as well as auditors busy first, interpreting the guidance, and then arguing (discussing) over its meaning within a particular context.
So here’s the five step framework for measuring and reporting revenue (and looks so simplistic, just like the fair value hierarchy looked at first pass):
Collect and record all company contracts. Clearly note the customer in the transaction.
Identify the performance obligation in the contract. What are the responsibilities of each party and what is the time frame within which these responsibilities must be fulfilled.
Determine the contractual price.
Allocate the price you’ve determined in Step 3 to the performance obligations you’ve identified in Step 2. Take the groundwork of the two previous steps and come up with an allocation method. Yes, more judgment and modeling.
Finally, recognize that the performance obligation is satisfied and record the revenue in the financial statements.
The game plan
Taking apart the five steps, you can see that Step 1, while time-consuming and laborious, is mostly likely going to be your easiest. You are simply creating a database of information that you are going to be analyzing in the next four steps.
Next, you will need to define what constitutes a performance obligation in every contract. There are several key points to keep in mind:
1. A performance obligation is a promise to transfer a good or service
2. It can be explicitly stated or implied by customary business practices
3. It can be distinct or part of a series of distinct goods or services
4. It can be fixed-term, fixed-price or variable-term, variable price, or a mix of both
5. Contracts with similar performance obligations should be treated consistently.
Some of the questions that can arise as you, and possibly your legal counsel, consider the contractual obligations in each instances might be:
1. At what point does transfer occur?
2. What is spelled out in the contract and what is assumed?
3. Can we say the obligation is distinct? That is, can the customer benefit from the good or service on its own?
4. Or is the obligation part of a series? That is, are there other steps must be completed before the customer can benefit, and therefore, any particular step on its own constitutes incomplete performance?
5. Is there an enforceable clause to compel the customer to pay at each step of the contract if it consists of a series of performance obligations?
Teasing out the meaning of performance obligation will be a matter of careful consideration of all of the terms of the contract and the business practices prevalent in your particular industry as well as the framework of the revenue recognition standard. It will require combing through and really digging into the details such as steps to performance fulfillment, time horizon for each step, other parties involved, any variable performance hurdles, and considering the extent to which those details matter to the usability of the good or service you are providing. This is step is all about the interpretation of the contractual language while the next step introduces valuation.
After doing your thorough research and documenting your conclusions as well as the literature supporting them, you will have to assign a transaction price to the performance obligations within your contracts. This is where matters are likely to get complicated. Unless you are dealing with a fixed price, straightforward contract (and you’ll probably need to get your legal to nonetheless, state that its fixed price and straightforward), expect to have lots of discussion on how the different stages of the variable performance thresholds are crossed and how each should be valued. There are two methods you can use to assign value to the contract as the different steps in the series of obligations are completed — the output method and the input method. The output method is concerned with the final value of the good or service to be delivered, and the measurement towards completion involves estimated how much was already produced versus how much still remains to be produced. Think of it as — what is the total value that was already transferred to the customer versus how much value will be transferred in the future. The input method, on the other hand, is concerned with measuring the efforts expended to date (i.e. labor hours) versus the total effort expected to complete the contract. Here, the measurement is based on some internal input of the producer of the good or service that is necessary to realize the work under the contract. As these are markedly different approaches, the inputs into your valuation model as well as the outcome will be different. You will have to decide what is the soundest choice given your situation.
Once you’ve determined what’s distinct and what’s bundled, teased out all of the performance terms and thresholds, then it’s time to allocate the value to the performance obligations. That value is the transaction price. There will significant amount of judgement involved here especially around the inputs into your financial model and the assessment of the constraints you can foresee with respect to the delivery of the good or service. Remember that consistency matters. While you can use different valuation methodologies for different contracts, those contracts that are substantially similar should be valued using similar valuation approaches. Additionally, unless the contract is substantially modified from one valuation period to another, the same methodology used at the inception of the contract should be used to value it throughout its life. The FASB does offer some help by setting the foundation for what represents a transaction price. Your own valuation model will be built from this starting point where FASB defines the transaction price as a standalone selling price, and the concept of the standalone selling price sounds a lot like the fair value methodology. The best evidence of such price is an observable price that is used to sell the good or service to similar customers in similar circumstances. Doesn’t this sound like Level 1 in the fair value hierarchy? If the price is not observable and cannot be transacted upon, then you will have to estimate it based on one of the three methods — adjusted market approach, expected cost plus margin approach and residual approach. If there’s another method that makes sense in your business setting, you may use it so long as you can justify it. Once you have calculated the transaction price, apply it to the terms of the contract either at once or in stages.
And now, you have arrived at the final step. It is time to recognize revenue in the financial statements. Having done the groundwork of identifying the variable thresholds and assigning value to them, you have a good understanding of the point in time when control passes from you, the seller, to the buyer. You also have the value that you have assigned to each time period and the underpinning valuation methodology that allows you to make any adjustments that might be appropriate. For a contract with no variable thresholds, all of revenue is recognized at the point of transfer of control.
For over a decade the FASB and the IASB have been working on standardizing accounting rules to create a comprehensive set of guidance that applies globally. Think about how easy it would be compare the financial statements of a French company with those of a US company, if you didn’t have to make any adjustments from IFRS to GAAP! And though there are only a handful of these common standards at the moment, we are headed in the right direction. It will likely to take another decade to get to the finish line, however, getting two regulatory bodies to agree on a set of accounting principles is no small feat and to standardize reporting across continents is even more impressive. This is only the beginning….