Companies are beginning to reconsider certain aspects of how they do business as they adapt to new accounting rules.
At last week’s Compliance Week 2018 conference, partners at Deloitte said certain changes in accounting rules for leases and revenue recognition are driving discussions about whether companies should change the way they manage contracts and compensate certain employees. The discussions seem a little more advanced in the context of new revenue recognition rules, but lease implications are causing some reflection. Even new rules for recognizing loan losses are driving new conversations at financial institutions.
A new, five-step method for when and in what amounts to recognize revenue in financial statements took effect for calendar-year public companies beginning on Jan. 1, 2018. Accounting Standards Codification Topic 606 (or ASC 606) wiped out hundreds of historic prescriptive requirements for how to recognize revenue and replaced them with a single, principles-based, comprehensive method that is intended to make reporting more consistent and more comparable across entities, across sectors, even across jurisdictions.
Now in 2018, public companies are gearing up for the next big accounting change, which brings virtually all leased assets and their related liabilities out of footnotes and onto the face of corporate balance sheets. ASC 842 on leases takes effect for calendar-year public companies on Jan. 1, 2019. Private companies have an additional year on both standards, so they will adopt revenue on Jan. 1, 2019, and then leases a year later.
Changes in the way companies recognize revenue are driving discussions about whether companies should more closely examine how they arrive at contracts with customers and whether they should reconsider certain compensation practices, said Chris Chiriatti, a partner at Deloitte & Touche. “Those are the two most impactful areas,” he said.
According to the new rules on revenue recognition, any incremental costs a company incurs to obtain a contract or fulfill a contract that are expected to be recovered over time must be treated as assets, not direct expenses. Sales commissions represent the most common example.
A salary paid to a sales person is an expense, regardless of whether the company wins any particular contract as a result of paying that salary. A commission, however, is a cost typically tied to a specific contract or transaction, which the company will recover over the life of the arrangement. Under the new accounting rules, that means salary is an expense recognized as incurred, but the commission is more like an asset.
Where a commission must be treated as an asset under the new rules, that means it must be added to the balance sheet and amortized, or written down period after period like a depreciating asset, over the expected life of the contract. That caught many companies by surprise as they worked through implementation.
“As companies review their compensation plans and commission structures, they see tremendous variety. So they view this as an opportunity to get some consistency.”
Chris Chiriatti, Partner, Deloitte & Touche
“As companies review their compensation plans and commission structures, they see tremendous variety,” said Chiriatti. “So they view this as an opportunity to get some consistency.”
Companies are also looking at modifications if they don’t like the accounting they get under the new rules. Now that they better understand what will be expensed and what will be capitalized, “to some extent they are modifying (compensation plans) to drive a certain accounting outcome,” Chiriatti said.
Contracting practices also are under the microscope in many organizations, Chiriatti said. The new accounting method requires companies to identify their contracts with customers, identify their separate performance obligations in each contract, allocate the purchase price to those obligations, and then recognize revenue only as each obligation is met.
That exercise of parsing through contracts and seeing how they are accounted for has led companies to think through their contracting processes, said Chiriatti. Over time, companies may have developed inconsistent approaches to establishing contracts, which has produced different accounting effects under the new rules.
Business leaders might now be looking to get more consistent accounting, which means they need more structured ways to arrive at more consistent contracts. “They’re looking to have better discipline about how they go to market,” he said. “They’re also seeing some business risks, maybe some risks in contracts that is not acceptable.”
With respect to leasing, companies are not as far along in making changes to their business, but current implementation activities are prompting some consideration of what might change in the future.
“I’m hearing a lot of discussion about whether they should change the criteria for lease versus buy, or having more bargain purchase price options at the end of the lease—more variable payments to fixed payments,” said Jeanne McGovern, also a partner at Deloitte & Touche. “I hear a lot of discussions, but I’m not really seeing it happen yet.”
For now, companies are still quite busy simply trying to transition to the new accounting, and by many indicators they have a lot of work to do in the time that remains, said McGovern. “I’m a little bit worried when I see studies that say only 20 percent or 21 percent of companies feel ready for this standard,” she said.
To the extent companies are considering changes to business processes now, it’s more focused on simply taking stock of how the company may have committed to different kinds of lease arrangements for similar assets. “Companies are seeing their internal policies and business processes need to be more aligned across the organization,” she said.
Companies are also recognizing through this process they will get greater visibility into what their peers are doing, said McGovern. If one retail giant is leasing space with five-year commitments and another committing to 10-year leases, those will look very different on balance sheets. Once those differences begin showing up in financial statements, companies may rethink their strategies.
The duty of compliance officers as companies adapt to those major accounting changes is to tune in to the nature of the changes, understand how it may drive changes to the business, and take stock of any risks. “You can be a great communication vehicle to assure all parts of the organization understand,” said McGovern. “Be sure there’s an appropriate timeline (for adoption), that milestones are being met, and that the right communication is going to senior management and the audit committee or board about those milestones.”
Given the significant judgments that must be exercised under the new standards, especially revenue recognition, compliance officers should be vigilant about understanding judgments and looking for inconsistencies, said Chiriatti. “It’s really important to understand what the new processes and controls are and the key judgments management is making that could be susceptible to risk,” he said.