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Revenue from Contracts with Customers Standard: Impact on Manufacturers

9/17/19 – Kristin Leadingham

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The revenue recognition guidelines under ASU 2014-09, Revenue from Contracts with Customers, replace nearly 180 pieces of industry-specific guidance in GAAP with a broad, principles-based method for most businesses to recognize revenue. (See “5 Steps to Recognize Revenue,” below.) This approach to revenue recognition is more closely aligned with international financial reporting rules.

The changes will be significant, especially for manufacturers and distributors who enter into specialized, long-term contracts with customers. For some companies, the updated guidance will result in earlier revenue recognition or delayed revenue recognition compared to current practice. One reason this could occur is that the standard will require companies to estimate the effects of items such as sales incentives, discounts and warranties. The standard also provides guidance on service revenue and contract modifications.

Nearly all manufacturers and distributors will need to beef up their footnote disclosures under the standard. The update requires detailed breakdowns of revenue by product lines, geographic markets, contract length, services and physical goods.

The revenue recognition guidance went into effect for public companies in 2018 and private companies in 2019.

Proactive manufacturers who have started the implementation process forewarn of the challenges. Christine DiFabio, assistant controller at Zoetis, a manufacturer of animal medicines, said during a panel discussion at Financial Executives International’s Current Financial Reporting Issues Conference, “For those people who haven’t started or are very early [along], try to start to speed it up, because while you may not think it will have a significant impact financially, it’s a significant impact in workload — and documentation efforts as well.” She described the accounting change as “all encompassing.”

Michael Cleary, Boeing vice president of accounting and financial reporting, also acknowledged during the panel discussion that the changes under ASU 2014-09 would significantly alter when his company records revenue. Boeing’s customer contracts are typically long-term and complicated, so he formed a steering team, including officials from the communications and human resource departments, tasked solely with implementing the standard.

5 Steps to Recognize Revenue

Accounting Standards Update (ASU) No. 2014-09 will require companies to follow five steps when deciding how and when to recognize revenue:

  1. Identify a contract with a customer.
  2. Separate the contract’s commitments.
  3. Determine the transaction price.
  4. Allocate a price to each promise.
  5. Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.

Understanding Your Contracts with Customers

One of the most critical aspects of the standard requires companies to gain an understanding of their contracts with the customer for providing goods and services. Revenue is recognized to depict the transfer of the promised goods or services that will reflect the total consideration to which the entity expects to receive.

Under the standard, a contract is an agreement between two or more parties that creates enforceable rights and obligations. A contract with a customer exists when all of the following criteria are met:

  1. The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations.
  2. Each party’s rights regarding the goods or services to be transferred can be identified.
  3. The payment terms for the goods or services to be transferred can be identified.
  4. The contract has commercial substance.
  5. It is probable the Company will collect the consideration to which it will be entitled in exchange for the goods or services to be transferred.

There are many aspects of the contract that can affect the amount of revenue recognized or even when revenue is recognized. The following are some items that could have an impact:

  1. Contract modifications.
  2. Variable consideration including discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, reimbursement of out-of-pocket expense, or similar items.
  3. Sale with a right of return.
  4. Service warranties.
  5. Discounts.
  6. Principal vs agent considerations.
  7. Consignment arrangements.
  8. Bill-and-hold arrangements.
  9. Promise to provide future goods.

Next Steps

As companies continue to navigate the implementation of this standard, below are some steps that can help along the way:

  1. Gather Information:
    • Make sure those involved in the financial reporting process are all on the same page and receive the appropriate training and education.
    • Take an assessment of all revenue arrangements and group those with similar terms and conditions.
  2. Sample Contracts:
    • Select a sample of contracts to review. It is helpful to break the contracts down first by those with similar terms and conditions and those with unique characteristics.
    • Select a sample from each material revenue stream to review. Each revenue stream may be treated differently for revenue recognition.
  3. Assess:
    • Evaluate the contracts selected using the 5-step approach. (We have a spreadsheet that will help you through this evaluation.)
    • Identify the difference between prior GAAP guidance and the current standard. These differences will help you understand what changes need to be made in your controls and processes.
  4. Implement Controls:
    • Once you have evaluated your contracts and determined how revenue will be recognized, it is important to implement controls that will ensure the standard is properly implemented.
    • Make sure the entire team is aware of the changes that are being made and the importance of the changes.
  5. Provide Additional Disclosures:
    • Even if there is no financial impact, there are also new financial statement disclosures that are required. Make sure to gather the necessary information to provide those required disclosures.

Compared to prior GAAP, the updated guidance will require companies to exercise greater judgment when recognizing revenue. VonLehman’s revenue recognition experts can help you make informed decisions based on the terms of your customer contracts. Be on the lookout in the coming weeks as we continue to update manufacturing and distribution companies on all things revenue recognition.