Strategizing for Global Financial Reporting Changes:

8 Steps You Can Take Now to Prepare for the New Revenue Recognition Standard

By Karen Doerner, CPA, Partner

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The core principle behind the new standard is

“to depict the transfer of goods or services

to customers in amounts that reflect the consideration to which the company

expects to be entitled in exchange for those

goods or services.”

In May 2014, six years’ worth of planning, meetings, deliberations and proposals finally resulted in the convergence of a revenue recognition standard acknowledged by both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). This means that much of the existing Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) revenue recognition guidance will be replaced, making the potential impact to organizations worldwide significant. This update, Revenue from Contracts with Customers, will affect both public and private entities that enter into contracts with customers.

What is the New Revenue Recognition Standard?The new revenue recognition standard is a roadmap for organizations across the United States and in other countries to recognize revenue resulting from contracts with customers uniformly. Because recognizing revenue is an essential measure stakeholders use when evaluating an organization’s current and future performance, the new revenue recognition standard makes consistent the financial information reported for those organizations. According to the FASB, the core principle behind the new standard is to recognize revenue “to depict the transfer of goods or services to customers in amounts that reflect the consideration to which the company expects to be entitled in exchange for those goods or services.” Additionally, the new standard will provide improved disclosures about revenue, guidance for transactions that have not yet been addressed thoroughly (including service revenue and modifications to contracts) and direction for multiple-element arrangements.

When Will Revenue Recognition Take Effect?Revenue recognition will go into effect for reporting periods beginning after December 15, 2016 for public entities, including interim reporting periods therein; and after December 15, 2017 for private entities, and interim reporting periods within annual reporting periods beginning after December 15, 2018. Public entities may not early adopt the standard and non-public companies may only early adopt on the public entity adoption date, but no earlier.

Acknowledged by:

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As a practical matter, companies need to understand the accounting changes much earlier than these dates; at least a year prior to implementation and for comparative statements for all the years anticipated to be presented depending on the transition method selected. For example, a calendar year-end private company would implement the new standard for the year ended December 31, 2018. If the full retrospective method is used for a two-year comparative financial statement, the adjustment for any cumulative effect of the change in accounting would need to be calculated and identified as of January 1, 2017.

8 Steps Organizations Can Take to Prepare for Revenue RecognitionEven though you won’t be required to make any changes for a few more years, there really is little time to waste. Here are the eight steps we recommend taking now or in the very near future to begin preparing for revenue recognition changes.

Begin understanding the new revenue recognition standard.

We aren’t recommending that you read the 700-page revenue recognition report—we know that doesn’t exactly sound appealing. But you should talk to your auditor. Attend any informational seminars on the topic. Read pieces like this one. By gaining a basic understanding of the new model, you will be better equipped to evaluate what you may need to change in your accounting for contracts.

1 Create a revenue recognition project team.

By establishing a project team comprised of a cross-section of individuals, you are improving how well your organization understands and prepares for this change. This project team should include individuals from your accounting, sales, project management and legal departments, and they should be responsible for not only developing a transition and implementation plan, but also educating other employees on their roles in the changes that will take place.

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Identify where your gaps lie.

Once your project team has an understanding of the new standard—they will likely want to discuss specifics with your organization’s accounting firm—they can begin to determine where there are gaps between current accounting procedures and what will be required under the new standard. A few things your project team can do to identify any gaps include analyzing current revenue policies and pinpointing what information will be needed for new contract estimates.

3 Build a project timeline.

Knowing the effective date of the new standard, it likely makes the most sense for your organization to work backward. There is no average length of time it will take for organizations to complete their transition plans, as it depends entirely on how many individuals are dedicated to working on this project, how large your gaps are, how many clients you have and how many contracts will still be open after the new standard takes effect. Your best bet is to talk to your accounting firm about what timeline will work best for you.

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Consider internal controls and business practices implications.

It is possible that after knowing these, you may need to decide whether to change your organization’s business practices (or maybe not). Are there aspects of business operations you can alter to deliver improved results or simply make the revenue recognition process easier?

5 Consider tax implications.

A decision you’ll likely have to make is identifying how many years you will show in financial statements for 2017 or 2018, primarily for private entities. For every year you show, you will need to ensure that all those years are using the new standard. As an example, let’s assume you are a private entity. If you decide to show more than one year on your 2018 financial statements, you will need to go back and look at all contracts that were not completed by the end of 2016. On the other hand, if you decide to show only a single year, you will only have to be concerned with the contracts that start in 2017 and won’t be complete until 2018 or later.

6

Consider technology implications.

If your organization currently uses or is in the process of implementing a technology solution that integrates with your financial reporting, you should determine whether or not that solution has the functionality to effectively sync up with how you will be required to recognize revenue.

7 Decide on a transition approach.

If you have contracts that are set to be complete before the new standard takes effect, you don’t necessarily have to worry so much about those. However, if you have open contracts that aren’t set to be complete until 2018 or later, those contracts may be affected. Additionally, taking the time now to make a process for reviewing all forthcoming contracts will make your life much simpler in the long run, once the changes take effect.

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1. Understand the new standard

2. Establish a project team

4. Build a project timeline

3. Identify the gaps5. Consider internal

implications

6. Consider tax implications

7. Consider technology implications

8. Decide on transition approach

Preparing for Revenue Recognition

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Adoption of Revenue RecognitionIn order to create consistency among how revenue will be recognized, the FASB and IASB developed a five-step model that organizations will use moving forward.

The Five-Step Model Step 1: Identify the contract with a customer.

Step 2: Identify the performance obligations in the contract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price.

Step 5: Recognize revenue when or as the entity satisfies a performance obligation.

To better understand this five-step process and how it relates to your preparedness, we will dive into each of the steps.

Step 1: Identify the contract with a customer.For purposes of revenue recognition, a contract is defined as a written or oral agreement between two or more parties that initiates enforceable and legally bound rights and responsibilities. Since organizations vary when it comes to how they establish contracts—for example, a mid-sized manufacturer likely has much different processes than a not-for-profit—it is up to you as an organizational leader to determine whether or not the agreement can be legally defined as a contract. Contract terms can be identified in multiple communications, such as purchase orders, acknowledgments and invoice terms.

However, two criteria that universally determine that a contract does not exist include:

1. Your organization has not yet transferred any promised goods or services to the customer.

2. Your organization has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services.

The updated revenue recognition standard defines when you should account for a contract with a customer using the following five criteria:

1. All parties have approved the contract and intend 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 can be identified.

4. The risk, timing or amounts of your organization’s future cash flows are expected to change.

5. It is probable that your organization will collect the consideration to which it will be entitled in exchange for goods or services transferred.

While these five criteria are clear-cut for the most part, the fifth criterion is not as black-and-white. It is important to note that when determining whether it is probable that payment will be collected, you should consider only the customer’s ability and intention to pay at the time it is due, rather than focus on the price stated in the contract.

There are a couple side notes when it comes to identifying contracts with customers—the combination of two or more contracts and contract modifications.

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Combination of ContractsWhen you establish two or more contracts with the same customer around the same time, you may be required to combine those contracts and account as one contract for purposes of revenue recognition, if these criteria are met:

The contracts are negotiated as a package with a single commercial objective.

The amount of consideration to be paid in one contract depends on the other price or performance of the other contract.

The goods and services promised in the contracts are a single performance obligation, in accordance with the standard.

Contract ModificationWhen an approved change is made to the scope or price of an existing contract, it is possible for the party transferring goods or services—your organization—to account the modification as a separate contract for purposes of revenue recognition, if these criteria are met:

The scope of the contract increases because of the addition of distinct promised goods or services.

The price of the contract increases by an amount of consideration that reflects your stand-alone selling prices of the additional promised goods or services, and any appropriate adjustments to that price to reflect the circumstances of the particular contract.

Step 2: Identify the performance obligations in the contract.Under the new standard, each contract may have multiple performance obligations, or the promise of the transfer of goods or services. When establishing a contract with a customer, you should identify each separate performance obligation as either a distinct good or service, or a series of distinct goods or services that are substantially similar.

A good or service can be classified as distinct when two criteria are met:

1. The customer benefits from the good or service on its own or in conjunction with other available resources.

2. Your organization’s promise to transfer the good or service can be clearly identified as separate from other performance obligations in the contract.

It is important to note that performance obligations may include more than just the goods or services stated in the contract. Performance obligations may extend to implied promises, such as business practices customary to your organization. Other performance obligations may include:

� Sale of goods produced by your organization

� Resale of goods purchased by your organization

� Resale of rights to goods or services purchased by your organization

� Performing a contractually agreed-upon task

� Being “on call” to provide goods or services

� Arranging for another party to transfer goods or services to a customer

� Granting rights to goods or services for future use

� Constructing, manufacturing or developing an asset on behalf of a customer

� Granting licenses

� Granting options to purchase additional goods or services

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Step 3: Determine the transaction price.The new revenue recognition standard defines the transaction price as the payment amount to which an organization expects to receive in exchange for transferring promised goods or services to a customer. Determining the transaction price is based on five factors, and you should always consider the contract’s terms and your own customary business practices when doing so.

Variable ConsiderationIf the payment promised in a contract includes a non-fixed amount, it is appropriate to estimate the final, full payment amount you expect to receive in exchange for transferring the promised goods or services. You should estimate variable consideration using one of these methods:

The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. This may be appropriate to use if you have a large number of contracts with similar characteristics.

The most likely amount is the single most likely amount in a range of possible consideration amounts, and may be appropriate to use if the contract has only two possible consideration outcomes.

Constraining Estimates of Variable ConsiderationSome or all of the variable consideration should be included in the transaction price if the chances are high that the consideration will remain unchanged or only slightly changed. Factors that could increase those chances include:

The amount of consideration is highly susceptible to factors outside your organization’s influence, such as market volatility and weather conditions.

You don’t expect the amount of consideration’s uncertainty to be resolved soon.

Your experience with similar types of contracts is limited.

It is customary for your organization to offer discounts or change payment terms.

The contract has several possible consideration amounts, and within a broad range.

Significant Financing ComponentIf one party clearly holds a significant benefit when it comes to payment terms, the contract should be adjusted to contain a significant financing component. When adjusting the consideration for this, revenue should be recognized at an amount reflective of the price that would have been paid to you at the time the goods or services were transferred. To determine if your contract contains a financing component, consider:

The difference between the amount of promised consideration and the cash selling price of the promised goods or services.

The combined effect of both the expected length of time between when you transfer the promised goods or services to the customer and when the customer pays you for those; and the prevailing interest rates in the relevant market.

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Non-Cash ConsiderationsThe transaction price should also include other promised considerations not in the form of cash, such as stock shares. There are a few factors to keep in mind:

If it is difficult to estimate this amount, you can measure the consideration indirectly by referencing the stand-alone selling price of the goods or services promised to the customer.

The fair value of any non-cash consideration may vary depending on its form, but if it varies for any other reason, i.e. your organization’s performance, you should apply guidance on constraining estimates of variable consideration.

If you use goods or services provided by the customer to fulfill the contract, you must assess who obtains control of those goods or services. If your organization obtains control, the goods or services should be accounted as non-cash consideration.

Consideration Payable to a CustomerIf a customer receives any considerations, it should be accounted for as a reduction of the transaction price unless the payment is in exchange for a distinct good or service that the customer transfers to you. If it is accounted for as a reduction of the transaction price, you should recognize the reduction of revenue when the later of these events occur:

Your organization recognizes revenue for the transfer of the related goods or services to the customer.

Your organization pays or promises to pay the consideration (even if the payment is conditional on a future event).

Step 4: Allocate the transaction price.The new standard states that if a contract has more than one performance obligation, you must allocate the transaction price to each individual performance obligation. To do this properly, you should determine the stand-alone selling price—the price at which you would sell this good or service on an individual basis—for each good or service at the contract’s inception. If you aren’t able to directly observe this stand-alone price, it is appropriate to estimate it, but you will need to consider all available factors, including market conditions.

If the transaction price includes a discount for purchasing a bundle of goods or services, you should allocate that discount proportionately to all performance obligations, except when you have clear evidence that the discount in its entirety relates to only one or more (but not all) of the performance obligations.

Similarly, if the transaction price includes variable consideration, you should allocate that amount entirely to a performance obligation or a distinct good or service that forms part of a single performance obligation. If the variable consideration is not allocated entirely to one of these, the remaining amount of the transaction price should be allocated based on the stand-alone selling price and discount.

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Step 5: Recognize revenue when or as the entity satisfies a performance obligation.The new standard states that you must recognize revenue when you satisfy a performance obligation; meaning, when you transfer a good or service to a customer, i.e. they obtain control of the asset. Performance obligations can be satisfied either at a point in time or over time.

If one of the following criteria is met, your organization satisfies performance obligations and recognizes revenue over time. If a performance obligation is not satisfied over time, it is satisfied at one point in time.

The customer receives and uses the benefits your organization provided through a good or service.

Your organization’s performance creates or enhances an asset that the customer currently controls.

Your organization’s performance does not create an asset that can be used alternatively for your organization, and you have an enforceable right to payment for performance completed to date.

To determine when the customer takes control of the promised good or service (thus, determining when to recognize revenue), take into account the following indicators:

� You currently have right to payment for the asset.

� The customer has a legal title to the asset.

� You have transferred physical possession of the asset.

� The customer holds the risks and rewards of owning the asset.

� The customer has accepted the asset.

The purpose of the new standard is to simplify and make consistent how organizations recognize revenue from contracts, so it only makes sense to begin as early as possible to ensure a smooth transition from the start. Regardless of whether your organization is a public entity or a private entity, following the eight steps we outlined earlier will put you on the right path.

Sikich has a committee dedicated to understanding the new standard and educating those it will impact. To discuss your unique situation with one of those committee members, please contact Karen Doerner, CPA, Partner at Sikich.

Karen Doerner, CPA

317.842.4466kdoerner@sikich.com