– RevenueRecognition.com Contributor
If Benjamin Franklin had been an accountant his famous quote might have read – nothing in this world is certain except for death, taxes, and changes to the revenue recognition rules.
Regardless of the rules that you now follow – the principles-based guidance promulgated by the International Accounting Standards Board (IASB), or the detailed, sometimes industry-specific, guidance issued in the U.S. by the Financial Accounting Standards Board (FASB) and other authoritative bodies – it is almost certain that the rules that you use for revenue recognition will be changing.
The IASB and FASB are currently working on a joint project to clarify the principles for recognizing revenue and to develop a single, common revenue recognition standard. A final exposure draft is planned to be issued very soon which would be the final step before a single, converged standard is issued.
In the future, for US GAAP companies, industry-specific guidance will be gone (e.g., software revenue recognition under ASC 985-605 [formerly known as Statement of Position (“SOP”) 97-2] and construction accounting under ASC 605-35 [formerly known as SOP 81-1]) and there will be the need to exercise more judgment for anything but the most simple transactions. For companies that follow the International Financial Reporting Standards (IFRS) there will be a more detailed and well defined process with more bright-line rules.
U.S. GAAP Companies
The Discussion Paper “Preliminary Views on Revenue Recognition in Contracts with Customers” notes that in US GAAP, revenue recognition guidance comprises “more than a hundred standards – many are industry-specific and some can produce conflicting results for economically similar transactions”(1).
This was clear to companies that sold software. In 1997 SOP 97-2 was issued which superseded SOP 91-1. This standard provided guidance on how revenue should be recognized when the transaction included more than incidental software. SOP 97-2 provided detailed rules that went beyond the general US GAAP revenue recognition guidance. It provided detailed guidance for accounting for postcontract customer support (PCS) (which was generally accounted for as a cost accrual under SOP 91-1). PCS was now generally viewed as a specific element that was deliverable within the transaction. Recording a cost accrual for it was no longer generally acceptable. As an element, revenue needed to be assigned to it. Under SOP 97-2, vendor specific objective evidence (VSOE) of fair value needed to be determined for the PCS if revenue was to be recognized for any delivered elements. These companies whose revenue transactions included software now needed to determine if their transactions fell within the guidance of SOP 97-2 or not. This determination could result in seemingly similar transactions being accounted for dramatically different, depending on which accounting rules were applied.
Over time more transactions were being drawn under the software revenue recognition rules as more hardware products included software. The rules governing these transactions then began to evolve and change as the rule makers considered these hardware with embedded software transactions and whether or not it made sense to apply the software rules to these transactions. Therefore, changes were made in 2009 with the issuance of ASU2009-13, which gave relief from the strict VSOE standard for transactions where the hardware and software functioned together to provide the essential functionality; and the issuance of ASU2009-14, that clarified which transactions fell under the software revenue recognition rules and which fell outside those rules. With the movement toward convergence there were also discussions that the accounting for many of these transactions was not reflecting the true economic substance of the transactions.
Even companies that do not follow the industry-specific guidance software revenue recognition rules of ASC 985-605 / SOP 97-2 are in for changes. Take for instance companies that apply the construction accounting rules under ASC 605-35 / SOP 81-1.
In the model proposed under the exposure draft, these companies would need to determine if they continuously transfer control of their goods and services to the customer under the contract; or if control is only passed as the completion of the work. In the latter case, no revenue could be recognized until control passed at the work completion. This could present a potentially huge change for construction companies that do not transfer control under the contract until the work is completed. Take for instance a company that manufactures aircraft. Previously, under ASC 605-35 / SOP 81-1 it may have determined that the most representative measure of progress under percentage of completion accounting was to recognize revenue each period based on the ratio of costs incurred to date compared to total costs expected under the contract. If under the current proposal, the company determined that each aircraft represented the performance obligation, and that control over each aircraft only transferred as they delivered each aircraft to the end customer, revenue could only be recognized as each aircraft was delivered.
Changes are also expected for companies outside of the software revenue recognition and construction accounting areas as well. Here is a list of a few of the expected changes (not all-inclusive):
• Collectibility issues would no long be recognized as a bad debt expense. Collectibility issues would be shown as a direct revenue reduction in a separate line directly below revenue (i.e., contra revenue).
• If a seller retains some rights to an asset solely as protection against the customer’s failure to comply with the terms of the contract (for example, when a entity retains legal title as protection against the customer’s failure to pay), those rights are protective rights and do not preclude a customer from obtaining control of an asset (2), nor the company from recognizing revenue when control is transferred.
• A customer may obtain control of goods, even in bill-and-hold situations. The exposure draft does not contain the current (and very rigid) US GAAP detailed bill-and-hold criteria.
• For contract acquisition costs it is proposed to recognize an asset for the incremental costs of obtaining a contract (e.g., sales commissions) that are recoverable in the contract.
• There are numerous, detailed disclosure requirements.
Companies that report under IFRS have somewhat the opposite challenge posed to US GAAP companies. IFRS has two main revenue recognition standards (IAS 11 Construction Contracts and IAS 18 Revenue). These standards are generally considered to be vague and inconsistent. It can be difficult at times to tell which standard applies, and the standards can be difficult and very judgmental to apply beyond simple transactions. For example, these standards provide limited guidance for transactions involving multiple components or multiple deliverables (1).
Companies that presently apply a principles-based IFRS model will need to now consider some bright-line guidance in applying the new proposed revenue recognition guidance. This ranges from revenue that does not need to be discounted for the time value of money when the contract has a significant financing component if the period between payment by the customer and the transfer of the promised good or service to the customer is one year or more (3); to the detailed core principle to recognize revenue (4):
1. identify the contract(s) with the customer;
2. identify the separate performance obligations in the contract;
3. allocate the transaction price to the separate performance obligations; and
4. recognize revenue when the entity satisfies each performance obligation.
It would be expected that a new, converged revenue recognition standard would take away some of the judgments that were previously applied by IFRS companies. The intention is that more bright lines would provide better comparability between companies in the same industry as well as better comparability between industries.
The Changes to Come
The new exposure draft is expected to be issued any time now (it was due at the end of September 2011 but now is more likely in the November / December timeframe). Once it is issued there will be a 120 day comment period where you can make your comments known to the FASB / IASB boards. Based on re-deliberations once the comment period has ended, it is expected that the boards will re-affirm their previous positions or may make slight changes to the proposed model to address valid concerns raised by constituents. However, at this point it is not expected that substantive changes would be made to the basic proposed model.
With that said, now is the time to prepare for the next change to revenue recognition accounting. Here is an approach that you should consider to prepare for the upcoming changes:
• Read the exposure draft to understand how it might impact your revenue accounting.
• Comment during the 120 day period on issues that don’t make sense to you or that you believe should be changed (along with your rationale).
• Take several representative contracts and apply the proposed rules for recognizing revenue. This may help in identifying significant changes or implementation issues, including potential system and process changes that you may encounter once the project is finalized.
• Stay abreast of the re-deliberations. Updates on the progress of the project are available from either the FASB or IASB websites.
• Once the new rules are finalized, prepare a detailed plan for how you will implement the changes. This may involve bringing together a cross-functional team to assess potential impacts across your company. There could be impacts in areas outside of accounting (e.g., sales commissions, debt covenants, etc.).
• Don’t delay in assessing the impact on your company. Once a final standard is issued it is expected that implementation will be required no earlier than January 1, 2015. However, it is expected that full retrospective application will be required. Therefore, you may need to apply to transactions beginning as early as January 1, 2013.
(1) December 2008 Discussion paper “Preliminary Views on Revenue Recognition in Contracts with Customers”, page 7.
(2) Exposure Draft “Revenue from Contracts with Customers” June 2010, para. 28.
(3) IASB website. Revenue recognition project. Summary of the boards’ re-deliberations to date.
(4) Exposure Draft “Revenue from Contracts with Customers” June 2010, para. 2.