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Will the New Revenue Recognition Rules Impact Your Financials?

Financial statements with pen on top and calculator to the left. New revenue recognition rules.

3/30/2016

Revenue is an important element in all businesses, a key indicator in determining performance. Currently FASB Accounting Standards Codification® contains revenue recognition guidance for multiple industries, each with unique reporting requirements. The Financial Accounting Standards Board (FASB) wanted to simplify these complex revenue recognition rules and create a uniform guidance that could be applied consistently across all entity types and regions, thus the addition of a new standard “Revenue from Contracts with Customers.”

Effective January 2018 for public companies and 2019 for private companies, all revenues are to be recognized using 5 steps to apply the core principle. “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 entity expects to be entitled in exchange for those goods and services.”

  1. Identify the contract with a customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligation in the contract
  5. Recognize revenue when (or as) the entity satisfies a performance obligation

Each step contains a series of criteria and considerations that requires entities to exercise professional judgment in estimating probable amounts to be collected and timing of performance obligations to be fulfilled.

But why do we care? We have 2-3 years before implementation. To get an idea of the complexity of these changes, see the following “Example 1” from ASC 606-10-55:

A real estate developer enters into a contract with a customer to sell a building for $1 million. The customer intends to open a restaurant in the building. The building is located in an area where new restaurants face high levels of competition, and the customer has little experience in the restaurant industry.

The customer pays a nonrefundable deposit of $50,000 at inception of the contract and enters into a long-term financing agreement with the entity for the remaining 95 percent of the promised consideration. The financing arrangement is provided on a nonrecourse basis, which means that if the customer defaults, the entity can repossess the building but cannot seek further compensation from the customer, even if the collateral does not cover the full value of the amount owed. The entity’s cost of the building is $600,000. The customer obtains control of the building at contract inception.

In assessing whether the contract meets the criteria, the entity concludes that the criterion is not met because it is not probable that the entity will collect the consideration to which it is entitled in exchange for the transfer of the building. In reaching this conclusion, the entity observes that the customer’s ability and intention to pay may be in doubt because of the following factors:

  1. The customer intends to repay the loan (which has a significant balance) primarily from income derived from its restaurant business (which is a business facing significant risks because of high competition in the industry and the customer’s limited experience)
  2. The customer lacks other income or assets that could be used to repay the loan
  3. The customer’s liability under the loan is limited because the loan is nonrecourse

Because of the preceding facts it is not probable the developer will collect and should not record the sale of the building until either:

  1. The developer can conclude it is probable they will collect
  2. Substantially all of the consideration from the contract has been received
  3. The contract has been terminated

The payments received from the restaurant owner will be treated as a customer deposit (liability) until such time as the developer determines the collection is “probable.”

This is one example of a list of five total criteria that all need to be met before revenue can be recognized (not to be confused with the five steps listed earlier). See ASC 606-10-55-93 for 63 in-depth illustrations of applying this new pronouncement.

This change is to be adopted one of two ways; retrospectively to each prior reporting period presented in the financial statements, or retrospectively with the cumulative effect recognized at date of initial application.

The retrospective adoption stresses the importance of gaining an early understanding of these changes in order to determine the information needed for disclosures and cumulative effect adjustments.

This pronouncement affects all entities that have contracts with customers. It is safe to say many entities will be affected. Whether it’s obtaining contract information for new disclosures, calculating probable estimates of variable consideration, recognizing revenue at blended prices due to a modification of contract for goods, or calculating book tax differences, an early understanding of these changes will help save time when this change is required. Please contact RINA to discuss how these new rules will impact your business revenue.

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