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Revenue Recognition Standard Will Level the Playing Field

Robert Herz | June 25, 2013

The Financial Accounting Standards Board and the International Accounting Standards Board expect to soon issue converged standards on revenue recognition.

For FASB, the issuance of the final standard will represent the culmination of an endeavor that has been in the works for over a decade. The project was added to its agenda in May 2002 and has been a joint project with IASB for many years. The issuance of what will effectively be a global standard on this major subject will, in my view, mark an important milestone in the history of U.S. and global financial reporting.

The undertaking was a true collaborative effort, and I congratulate everyone involved with the project, which included almost 50 FASB and IASB board members, scores of staff from the two boards, and thousands of stakeholders who participated in the very extensive due process on this project through comment letters, public roundtables, field visits to companies by board members and staff, discussions by FASB and IASB advisory groups, and industry workshops around the world.

Revenue is arguably the most important line item in the financial statements of most companies. It is critical to investors in performing their analysis and evaluation of companies. Existing U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards on revenue recognition were different and both needed improving. Current U.S. GAAP and Securities and Exchange Commission requirements contain extensive and detailed guidance addressing specific industries and particular transactions and arrangements, but the guidance was developed piecemeal over many decades and can result in inconsistent reporting for economically similar transactions.

At the other extreme, existing IFRS standards on revenue recognition contain only high-level guidance that can also result in inconsistent reporting. Some in the IFRS world look to the U.S. GAAP guidance to determine how to report revenue, while others rely on different guidance, including the revenue recognition polices they followed under their old national accounting standards. So the new converged standard on revenue recognition is intended to remove these inconsistencies between and within U.S. GAAP and IFRS in order to improve the comparability of reported revenue across companies, industries, countries, and the global capital markets. Also, because the new guidance is intended to better reflect the economics of different revenue-generating transactions and arrangements and will expand the required disclosures in this area, it should also provide more useful information to investors and other users of financial information.

The new standard is also intended to simplify the preparation of financial statements by reducing the number of complex requirements to which a company must refer in developing its revenue recognition policies and procedures. Under the new approach, companies will follow a five-step process to determine when and how much revenue to recognize relating to particular transactions and arrangements. Those five steps involve (1) identifying the contract with a customer, (2) identifying the separate performance obligations in the contract, (3)determining the transaction price, (4) allocating the transaction price to the separate performance obligations, and (5) recognizing revenue when (or as) the company satisfies each performance obligation. The standard will explain each of these steps, including how to apply them to some of the common features present in contracts and arrangements with customers for the sale of goods or services.

Once the new standard is issued, companies should begin carefully and systematically reviewing how the new requirements will apply to each of their types of contracts and arrangements with customers to determine the extent of new or different data that will need to be collected.

Additional implementation guidance will be provided in the standard with numerous illustrations addressing specific types of revenue transactions across various industries. Nevertheless, because revenue recognition is such a broad topic and because the new standard will replace the reams of transaction and industry-specific guidance contained in the existing U.S. GAAP and SEC literature, some are understandably concerned that the new standard will not provide sufficient guidance for them to correctly and consistently implement the new requirements. Recognizing this concern and in order to help foster a smooth and orderly implementation, FASB is planning to establish an implementation group to address common issues that arise in the transition to the new standard.

Moreover, FASB has decided to provide significant lead time for companies to implement the new standard which will not become effective for public companies for interim annual reporting periods beginning after Dec. 15, 2016, which means calendar-year companies will have until the first quarter of 2017 to transition to the new standard. Non-public entities would implement the new standard for annual reporting periods beginning after Dec. 15, 2017, and for interim reporting periods thereafter. Also, companies will be able to choose between two transition approaches to implementing the new revenue recognition standard. Under the first approach, companies can choose to apply the new revenue recognition requirements retroactively to all periods presented in their financial statements. Under this approach, a public company with a calendar year-end reporting cycle, would apply the new standard as of Jan. 1, 2017, and would restate its comparative quarterly and annual financial statements for 2015 and 2016.

Under the second approach, a company can choose to apply the new requirements prospectively starting in 2017, but would then need to disclose and explain in the footnotes the effect of applying the new standard on specific line items in its 2017 quarterly and annual financial statements. Under both transition alternatives, companies will have to do a cumulative effect adjustment to retained earnings for revenue transactions that have not been completed as of the date of initial application of the new standard: Jan. 1, 2015, under the first alternative, and Jan. 1, 2017, under the second option. By providing these alternatives, FASB and IASB  have tried to balance the needs of users for having information on the trend of revenues on an “apples-to-apples “ basis with the cost to preparers of having to track and report revenues under both the new and old revenue recognition requirements.

 The extent to which the new standard will change the amounts and timing of revenues your company recognizes will depend on the nature and terms of your contracts and arrangements with customers. Companies that sell goods on a cash basis, for example, or whose transactions with customers do not involve the sale of multi-element deliverables, the delivery of goods or services that span multiple reporting periods, and do not involve variable or uncertain consideration may see little or no change in their revenue recognition procedures. Conversely, companies that provide goods and services on credit or whose transactions with customers involve multiple elements that span multiple reporting periods , or that involve variable or uncertain consideration, may experience significant a changes in the amounts and timing of revenues they recognize under the new standard.  Some of the industries that may be most affected by the new standard include software, real estate, construction and other long-term contracting, and asset management.

 The new standard will also include a number of new quantitative and qualitative disclosure requirements relating to customer contract balances, remaining performance obligations that will give rise to reporting revenues in future periods, assets recognized relating to costs to fulfill customer contracts, onerous performance obligations, and significant areas of judgment in applying the revenue recognition requirements.

 For many companies, implementing the new requirements will be a very significant undertaking. Accordingly, once the new standard is issued, companies should begin carefully and systematically reviewing how the new requirements will apply to each of their types of contracts and arrangements with customers to determine the extent of new or different data that will need to be collected.  Preparers will also need to consider changes in systems and internal processes, which transition approach to use, the potential impacts on reported results , balance sheet amounts, trends in reported revenues, earnings, bond and loan covenants, compensation plans, and other contractual arrangements that are tied to the company's reported financial information. Companies that will see significant changes from the new requirements will also need to put in place internal and external communication programs to key stakeholder groups and should be mindful of the SEC requirements relating to disclosure of the expected  effect of new accounting standards that are not yet effective, providing more detailed and specific disclosures as the date of initial application of the new standard approaches.

 Implementing the new revenue recognition standard will entail significant effort and cost by many companies and across the whole reporting system. However, I believe it represents a significant improvement in accounting and financial reporting in a very important area. Additionally, because FASB and IASB will be issuing converged standards, I believe it also represents a major step forward in achieving greater comparability of reported financial information across the global capital markets.