The Role General Counsel Can Play in the New Revenue Recognition Standards

Transcription

1 Authors Bernard Woolfley Navigant Direct: Kevin Davis Navigant Direct: The Role General Counsel Can Play in the New Revenue Recognition Standards Just like other types of regulations or rules, the rules used by accountants (known as Generally Accepted Accounting Principles, or GAAP) change from time to time to address a unique change in the market or a specific issue within an industry. Given the much-focused nature of these changes, the number of companies affected is often small. However, that is about to change, and all constituents within a company need to be ready. In 2018, the accounting rules for recognizing revenue on a company s financial statement in both the United States and abroad are going to change. The impact of these changes will, over time, have a transformative effect on a company s financial statements. Revenue (along with profit) is one of a company s key metrics of financial performance and these changes will affect how (and when) revenue is recorded on most large transactions. It also bears mentioning that the manipulation of revenue recognition has historically been at the heart of many significant accounting scandals and, as such, the implementation of this change will be closely watched by analysts, regulators, and auditors. Due to the broad nature of the changes, all companies and all departments within a company that interact with the accounting function will be affected, and the general counsel s office will be no exception. Revenue Recognition Changes The Background In accounting departments across the country, the question How do we recognize revenue under this contract? is a common question that comes up almost every week. While the answer is sometimes simple, it is not always black-and-white, since there is not one specific standard to Page 1 of 6

2 follow. To answer this question, chief accounting officers currently have to review GAAP guidance, interpretations set forth by the Securities and Exchange Commission (if the company is a public company), and international financial reporting standards (if the company has international operations). 1 There are industry-specific interpretations that need to be evaluated as well. There is no simple answer. In an attempt to stream-line this literature and consolidate the standards for revenue recognition in one place, in May 2014, the FASB issued Accounting Standards Update No , Revenue from Contracts with Customers and the IASB issued IFRS 15, Revenue from Contracts with Customers. 2 These revenue recognition standards eliminate the transaction and industry-specific revenue recognition guidance under current GAAP and replaces it with a principle-based approach for determining revenue recognition. 3 Basic Change The core principle of the new standard is that a company (public, private, or not-for-profit) should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those good or services. 4 While in theory this seems very simple and straightforward, as we all know, life is not that easy. We know that no two contracts ever seem to be the same, and certain contracts contain multiple elements that, while in the same contract, may need to be evaluated and accounted for as two separate transactions for the purpose of recognizing revenue. To correctly apply the new standard, and company should take the following steps: 5 1. Identify the contract(s) with a customer. The contract must be enforceable, identify the payment terms, and have commercial substance. Once it is probable the company will collect the consideration to which it is entitled in exchange for the goods or services, the new revenue recognition model can be applied. 1 Generally Accepted Accounting Principles (GAAP) are issued by the Financial Accounting Standards Board (FASB) and International Financial Reporting Standards (IFRS) are issued by the International Accounting Standards Board (IASB). 2 AICPA: Brief: Revenue Recognition Primer for Audit Committees, June Originally, these new standards were set to be effective in 2017, for calendar year public companies and 2018 for non-public companies. However, due to the complexities of implementation and at the urging of companies, both the FASB and IASB deferred implementation until 2018 for public companies and 2019 for non-public companies, with certain provisions for adoption on the original dates, if a company so chooses. 4 Accounting Standards Update No , Revenue from Contracts with Customers, Summary, What are the main provisions? 5 Accounting Standards Update No , Revenue from Contracts with Customers, Summary, What are the main provisions? Page 2 of 6

3 2. Identify the performance obligations in the contract. The company must evaluate the terms set forth within each contract and must identify each distinct performance obligation within that document Determine the transaction price. While this seems, on its face, to be an easy step, there are numerous factors to consider. The transaction price can include an estimate of the likelihood of the receipt of variable considerations; the effect of the time value of money if the customer is provided the benefit of financing; the fair value of any non-cash considerations; and the effect of any consideration payable to the customers such as credit, coupons, or vouchers. 4. Allocate the transaction price to the performance obligations in the contract. A company must allocate the transaction price to each separate performance obligation based upon the relative standalone selling price basis. In other words, how much would the good or service cost if sold on a standalone basis? If the standalone selling price of a good or service is not observable, an estimation must be used. 5. Recognize revenue when (or as) the company satisfies a performance obligation. A company satisfies a performance obligation by transferring control of a promised good or service to the customer, which could occur over time or at a point in time. Overall, revenue will be recognized when a company satisfies a performance obligation by transferring a promised good or service to a customer, which is when the customer obtains control of that good or service. However, as is clear through a reading of the new standards, considerable judgment and interpretation will be needed. Adoption of the New Standard 7 The new standard can be applied using one of the following methods: full retrospective or modified retrospective. Under the full retrospective approach, the company would restate the revenue recognized for prior periods for all contractual arrangements using the new accounting standards. 8 6 The key determinant is whether these obligations are distinct, a topic on which the literature provides guidance for making that determination. 7 AICPA: New Revenue Recognition Accounting Standard- Learning and Implementation Plan, January The literature does allow certain exceptions for contracts started and completed during the same reporting period and for completed contracts that were entered into with variable consideration. Page 3 of 6

4 Under the modified retrospective approach, a company would not restate prior periods presented, but rather would recognize the cumulative effect of initially applying the standard at the date of initial application. 9 Key Areas of Focus for General Counsel While the General Counsel s office is not usually highly involved in developing accounting conclusions, they will play a key role in assisting the Chief Financial Officer and the accounting department with the implementation of this new standard, especially the initial adoption. The following are several areas in which the General Counsel s office can provide assistance with the adoption. Understand the Implementation Plan and Strategy. A cross-functional project team should be in place to assess the new standard s potential impact on the company. A representative from the General Counsel s office should be on the implementation team, as there will be a need for a significant analysis of the population of customer contracts, which the General Counsel s office may have helped to create. Assist with the Review. As part of the implementation, there will need to be a review of the population of current customer contracts. The General Counsel s office should ensure that the accounting department in considering the entire population of contracts. Additionally, the General Counsel s office may need to provide assistance interpreting the contractual terms and any related contractual modifications. New Contract Development. Members of the General Counsel s office should assist with the development of new contracts that meet a company s business objectives as well as the company s financial accounting goals requirements. Educate and Inform. The General Counsel s office should ensure that the Board of Directors, and the Audit Committee specifically, is informed about the new standard and is regularly brought up to date on the progress that management is making toward adoption. 9 If a company chooses this method, there are additional disclosures required in the reporting periods that include the date of initial application. Page 4 of 6

5 Other Areas that Financial Management Should Consider As we have alluded to, the implementation of this new standard will likely impact almost every department within a company. Of key importance to the company will be to identify the key constituents and ensure that they are actively involved in the implementation plan and the goingforward approach for addressing revenue recognition within a company. In certain areas, the General Counsel s office could play a key role in ensuring that the right people are in place, especially when the data relates to contracts and contract terms. These could include: Standardization. Standardization of contracts and contract terms will be important. The more that and company modifies standard contracts, the more time and effort that will be needed to interpret the contract, consult with those who negotiated the contract, and develop an approach to monitor the activity of the contract to ensure that the accounting is appropriate. Capturing of Key Data Points. As with all financial information, the development of a systematic approach to capture data will be vital. Early in the development of the implementation plan, IT and systems specialists will need to be integrated into the team. The more the contract and accounting process can be automated, the easier implementation will become. It is imperative that IT employees are taught the key components of the new standards so they can develop an appropriate approach to capture data. Training. As part of the implementation plan, a process must be included to train the individuals who will be key members of the implementation team, as well as the accounting team. These employees will be vital in assisting with the implementation and evaluation/documentation of the accounting steps laid out above, such as determining what qualifies as a performance obligation and how it is met. Required Disclosures. Given the significant changes to the accounting for revenue, the type and level of disclosures will most likely need to change as well. The General Counsel s office and the accounting department should work hand-in-hand to understand the types of disclosures needed and, if not from the accounting department, where within the company the information needed for these disclosures will come from. Page 5 of 6

6 Conclusion While the accounting rules related to revenue recognition will now be in one standard, there will still be much complexity. The accounting department of a company will not be the only group impacted. The company will need to ensure that the right systems, processes, and resources are in place for a smooth and accurate initial adoption and that ongoing compliance is occurring. In many companies, the General Counsel s office will need to play a central role in assisting in the educating of employees and the continual monitoring to ensure that the company stays in compliance with the standards. Page 6 of 6