ready for change? revenue recognition. THE HIDDEN SIXTH STEP

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1 ready for change? revenue recognition. THE HIDDEN SIXTH STEP

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3 Revenue recognition The hidden sixth step After the new revenue recognition standards are implemented, will you still recognize your balance sheet? A hidden sixth step could affect key ratios and measurements on contracts entered into before the effective date. Given that the FASB s proposed new standard for revenue recognition is focused on revenue, it s no surprise that most of the discussion about the proposal has focused on the income statement. That certainly is an important part of the discussion, but it s equally important to remember that any discussion of revenue recognition is also a discussion of revenue deferral and, by extension, the capitalization of costs associated with the deferred revenue. Closer examination of the new guidance reveals that changes in this area may have material effects on balance sheet accounts that are used in measurements for everything from borrowing bases for lines of credit to commission payments to earnout agreements. The guidance discusses a 5-step process to analyze each contract in order to determine how your organization will recognize appropriate revenue under the new rules. In fact, our analysis of the guidance suggests that a hidden sixth step will be needed in order to fully understand the impact of the new standard on the balance sheet. PLANTE MORAN 1

4 A QUICK REVIEW OF THE FIVE STEPS The new standard requires that performance obligations under each contract be identified in order to appropriately recognize revenue under the new guidance. The following 5-step review process should be performed on each individual customer contract: 2 REVENUE RECOGNITION: THE HIDDEN SIXTH STEP

5 THE HIDDEN SIXTH STEP The five steps focus on when you recognize revenue. The hidden sixth step examines the related costs that are deferred and carried on the balance sheet. 6 Analyze the balance sheet impact of contract costs and contract assets and liabilities. In particular, the new standard provides guidance that may significantly change the way your organization accounts for contract costs and the manner in which it presents contract-related assets and liabilities on the balance sheet. CONTRACT COSTS Organizations often incur costs to obtain a contract that otherwise would not have been incurred. They also incur costs to fulfill a contract before a good or service is provided to a customer. The revenue standard provides guidance on costs to obtain and fulfill a contract that should be recognized as assets. Costs that are recognized as assets are amortized on a timeline consistent with the transfer of the goods or services to which the assets relate, and are periodically reviewed for impairment. Contract acquisition costs These are the costs your organization incurs to obtain a contract with a customer. Examples include selling and marketing, bid and proposal, sales commissions, and legal fees. Only incremental costs (costs an organization would not have incurred if the contract had not been obtained) are recognized as assets under the new standard. Under the old guidance, organizations had an option to capitalize or not capitalize such costs. Many organizations expensed these types of costs as incurred. Under the new guidance, organizations will be required to capitalize these costs. PLANTE MORAN 3

6 »» Example: Sales commissions. If your organization is not awarded the contract, you will not have to pay commissions. Organizations that do pay commissions when they win a contract must capture the sales commission costs associated with each contract and capitalize them under the new guidance. The asset will be amortized over the length of the contract with the customer. If organizations do not follow the new guidance and continue to expense sales commissions as incurred, assets on the balance sheet could be materially understated and expenses will be overstated. Costs to obtain a contract that are not incremental will continue to be expensed as incurred.»» Example: An A&E firm that engages specialists to help prepare the bid for a proposal. The money is spent on the proposal regardless of whether or not the company is awarded the contract. These costs would be expensed under both the old and new guidance, since the firm will have incurred this cost whether or not the contract was obtained. Organizations will need to consider all of the costs they incur when obtaining a contract and decide if they are incremental. We believe that sales commissions will be the most common type of incremental cost capitalized under the new guidance. Direct response advertising costs If your organization uses direct response advertising (such as mail-in coupons, business reply cards, or Internet hotspots), you should be aware that the new guidance supersedes and removes current FASB rules related to the treatment of these costs. Previously, companies could capitalize these costs if they met certain criteria. The new rules require organizations to determine if money spent on direct response advertising is an incremental cost attributable to a specific contract or if it is more accurately described as a non-incremental cost of doing business or a cost that cannot be attributed to a particular contract. In most circumstances, we believe that advertising costs, including direct response advertising costs, are not incremental and that organizations will be required to expense them under the new guidance. 4 REVENUE RECOGNITION: THE HIDDEN SIXTH STEP

7 Contract fulfillment costs These are the costs your organization incurs to fulfill its obligations after a contract is obtained. Examples include salaries and wages (direct labor costs) of employees who serve customers, direct materials used in providing service to customers, and any costs explicitly chargeable to a customer under the contract. Management must determine whether the accounting for these costs is addressed by other standards, for example, the guidance related to capitalization of inventory costs. Where other standards exist, management should apply those standards. Contract fulfillment costs not addressed by other standards are required to be capitalized if the following criteria are met:»» The costs relate directly to a contract that the organization can specifically identify,»» The costs generate or enhance resources of the organization that will be used in satisfying or continuing to satisfy future performance obligations, and»» The costs are expected to be recovered. In most circumstances, under old rules, organizations were able to choose whether or not to capitalize certain contract fulfillment costs. This option no longer exists.»» Example: Set-up costs Set-up costs are incurred at a contract s inception. They allow an organization to fulfill its responsibilities under the contract. They are common in software-related contracts where data migration may need to occur prior to the start of a contract. Under the old guidance, no specific standard addressed the capitalization of such costs. As a result, some entities chose to capitalize them while others expensed them. Under the new standard, these costs must be capitalized if they meet the criteria and are amortized over the term of the contract. PLANTE MORAN 5

8 PRESENTATION OF CONTRACT ASSETS AND LIABILITIES The presentation requirements under the new standard include a significant change from current practice. An organization will recognize an asset or liability if one of the parties to the contract has performed before the other. For example, if the organization performs its service in advance of receiving payment, it will recognize a contract asset or receivable in its balance sheet. If the organization receives payment before it performs its obligation under the agreement, a contract liability is recognized. This is not significantly different from current practice. The bigger change is that the revenue standard makes a new distinction between a contract asset and a receivable. The distinction is based on whether receipt of the consideration is conditioned on something other than the passage of time. A contract asset is an organization s right to payment in exchange for services or goods that it has transferred to a customer. A receivable is a different kind of asset than a contract asset. A contract asset is reclassified as a receivable when an organization s right to receive the consideration becomes unconditional (i.e., only the passage of time is required before payment is due).»» Example: An organization enters a contract to deliver two products to a customer. The products will be delivered at different times. The customer is not required to pay for either product until 60 days after both products have been delivered.»» Each product represents a separate performance obligation under the contract and control transfers to the customer upon delivery.»» When the first product is delivered, a contract asset should be created and revenue should be recognized for the portion of the consideration allocated to the performance obligation for the first product. 6 REVENUE RECOGNITION: THE HIDDEN SIXTH STEP

9 »» When the second product is delivered, a receivable should be created and revenue should be recognized for the portion of the consideration allocated to the performance obligation for the second product. A receivable is recorded rather than a contract asset because the organization s right to receive payment is based only on the passage of time. Accordingly, the contract asset created when the first product was delivered should be reclassified to a receivable upon delivery of the second product. Once the second product is delivered, the right of the organization to receive payment for the first product is no longer restricted by anything other than the passage of time. CONSIDERATIONS FOR EXECUTIVES Currently, the new revenue standard is scheduled to apply to public organizations in annual reporting periods that begin after December 15, 2017, and to nonpublic organizations in annual reporting periods that begin after December 15, While it s never too early to start planning for the change the new standard will have on your income statement, it s important to keep in mind that changes the new standard might make to balance sheets in the future could have an impact on some contracts your organization is signing even now. Here are a few examples: Lines of credit The borrowing base for some lines of credit are based on amounts reported in balance sheet accounts, most commonly accounts receivable. As described above, balances in accounts receivable may change as a result of the new standard. If your organization has a line of credit borrowing base related to accounts receivable, the new standard could have an impact on the amount of short-term credit your organization has available. Commission agreements If your organization relies on commission agreements to compensate employees, the treatment of those costs will change under the new standard. Commissions that are directly attributable to a specific contract will be treated as acquisition costs for that contract and they will be capitalized and amortized over the life of the contract. This treatment will shift the timing of the compensation expense. PLANTE MORAN 7

10 Earnout agreements Because the new standard will affect revenue and change what costs are capitalized, thus affecting expense recognition, earnout agreements that are expected to last beyond the rule s implementation date should take the changes into account. Depending on the organization, reported revenue could increase or decrease significantly without any actual change in the organization. On top of these potentially unforeseen consequences, CEOs and CFOs also need to consider the systemic changes that will be necessary to track activities in order to report financial information accurately under the new standard. The clearest example of this challenge is the new distinction between contract assets and receivables. Accounting systems designed to meet current standards may not be equipped to measure the point at which a payment no longer depends on anything but the passage of time. The systemic problem may be solved in part by providers of accounting systems and software, but organizations will still need to develop processes to identify this point in the performance of a contract. If you have any questions about the new rules or if you need assistance with the implementation process, please contact your Plante Moran engagement team or a member of our revenue recognition implementation team. 8 REVENUE RECOGNITION: THE HIDDEN SIXTH STEP

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12 Additional guidance can be found at revrec.plantemoran.com