Proposed Revenue Recognition Joint Standard for Customer Contracts Creates New Opportunities, Challenges
As the clock ticks down on the public comment period on the Exposure Draft, Revenue Recognition from Contracts with Customers, companies with multiple-element arrangements are looking toward a small handful of trailblazers to better understand how the sweeping changes being proposed will impact their organizations.
Specifically, they are looking to Apple, Cisco, Hewlett Packard and a number of other technology firms that have adopted EITF Issue 08-1 and EITF Issue 09-3, which change the way companies recognize revenues from bundled products and services, such as hardware, software, upgrades and maintenance. Several of the elements of EITF 08-1, which modifies the guidance in Topic 605 of the FASB Accounting Standards CodificationTM, are contained within the Exposure Draft that is open for public comment through Oct. 22, 2010.
“Before the amendment in EITF Issue 08-1, it was difficult for companies to separate elements in a multiple element arrangement. It was believed therefore that there were often uneconomic answers in revenue recognized in financial statements,” said Lynne Triplett, a partner in Grant Thornton LLP’s Accounting Principles Consulting Group. “If you didn’t meet the separation criteria, you had to account for all the contract elements together. That generally means that if you deliver a machine but install it later, you have to account for them together. You can’t recognize revenue when you deliver the machine. You have to wait.”
That limitation has already changed under the consensus in EITF 08-1, which was reached by the Financial Accounting Standards Board (FASB) Emerging Issues Task Force (EITF) in September 2009. Adoption becomes mandatory in the first quarter of fiscal year 2011 for calendar-year companies, although Apple and several others took advantage of the opportunity for early adoption.
Elements of the amended guidance in EITF 08-1 are also contained within the Exposure Draft, the core principle of which is that a company should recognize revenue when it transfers goods or services to a customer in the amount of consideration the company expects to receive from the customer.
Sweeping Changes on the Horizon
The Exposure Draft was developed and issued by FASB and the International Accounting Standards Board (IASB) as part of joint efforts to converge U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) into a single joint revenue recognition standard that companies can apply consistently across various industries and capital markets.
“It is an important step towards a single global principle-based standard that would make it absolutely clear when revenue is recognized,” said IASB Chairman Sir David Tweedle.
The Exposure Draft contains proposals that apply to contracts to provide goods or services to customers and dictate when to recognize revenue, how to measure it and what to disclose. The proposed standard, which would not apply to leases, insurance contracts and financial instruments, also requires enhanced disclosures and clarifies the accounting for contract costs. If adopted, the Exposure Draft would replace IAS 18 Revenue, IAS 11 Construction Contracts and related interpretations and supersede most of the guidance on revenue recognition in Topic 605.
“The proposed new standard not only seeks to reduce complexity by streamlining the way revenue recognition principles are applied across various industries and transactions, but it also aims at eliminating inconsistencies in existing revenue recognition standards and practices,” said FASB Chairman Robert Herz.
In a nutshell, as published in FASB’s June 2010 In Focus, a company would follow five steps to apply the proposed revenue recognition principles:
1. Identify the contract(s) with the customer (key proposal – price interdependence): A company would account for two or more contracts together if the prices of those contracts are interdependent. Conversely, a company would account for a single contract as two or more contracts if some goods or services are priced independently of other goods or services.
2. Identify the separate performance obligations (key proposal – distinct goods or services): A contract includes promises to provide goods or services to a customer. Those promises are called “performance obligations”. A company would account for a performance obligation separately only if the promised good or service is distinct. A good or service is distinct if it is sold separately or if it could be sold separately because it has a distinct function and a distinct profit margin.
3. Determine the transaction price (key proposal – probability-weighted expected amount): The transaction price is the amount of consideration a company expects to receive from the customer in exchange for transferring goods or services. The transaction price would reflect the company’s probability-weighted estimate of variable consideration (including reasonable estimates of contingent amounts) in addition to the effects of the customer’s credit risk and the time value of money (if material).
4. Allocate the transaction price to the performance obligations (key proposal – relative selling price allocation method): A company would allocate the transaction price to all separate performance obligations in proportion to the standalone selling price (estimated if necessary) of the good or service underlying each performance obligation.
5. Recognize revenue when a performance obligation is satisfied (key proposal – control): A company would recognize revenue when it satisfies a performance obligation by transferring the promised good or service to the customer, which is when the customer obtains control of the promised good or service. The amount of revenue recognized is the amount allocated to that performance obligation in Step 4.
“One overarching goal with the Exposure Draft is that the Boards are trying to develop a single model. So, for example, software would no longer have its own guidance” as it does under current Codification, and would be able to use estimated selling price, said Triplett. “The model incorporates some of the same concepts from EITF Issue 08-1. The terminology may be different but the meanings are the same.”
Those concepts relate to separating elements (or performance obligations) and allocating the transaction consideration, she noted.
A Peek behind the Curtain
Though not a true apples-to-apples comparison, the experiences of Apple and other early adopters of EITF 08-1 and EITF 09-3 do provide some insights into what companies can expect if the Exposure Draft is ultimately adopted.
Apple was one of the first to adopt the new rules, doing so for the first quarter of fiscal year of 2010 retrospectively. It enabled the company to accelerate recognition of revenue for some of its most popular products, which led to its most profitable quarter ever because Apple was able to recognize substantially all of the revenue and product costs at the time of sale.
Previously, Apple would have had to follow software guidance, which required that revenues be recognized via subscription-based accounting methods that are used when there are future deliverables associated with the product and the company lacks evidence of fair value for those future deliverables. In Apple’s case, those deliverables could be future iPhone upgrades that would have forced recognition of the device’s revenue over time.
Now, however, the company can use the relative selling price allocation method. As long as the software is considered essential to the product’s functionality, the company applies the guidance in EITF 08-1 and can estimate the selling price of each separate element in the bundle, recognize the revenue generated by the “delivered” portions and defer the balance.
By changing the way contract revenue is allocated, “it pulls an amount of revenue forward, although it doesn’t change the total amount. Companies [like Apple] are now able to separately recognize revenues for devices when they are sold. Previously, they had to recognize on a subscription basis,” said Triplett.
The acceleration of revenue recognition to more closely depict the timing of delivery is one potential benefit of the proposed rules. But it is not the only one. In fact, some may not even consider that the most significant benefit.
Triplett points to the clarity provided under a single model as the primary benefit of the proposed standard. Prior to Codification, there were around 200 pieces of revenue-specific guidance a company would have to consider to determine which was right for their particular transaction. Even post-Codification, “there is still a level of complexity that makes it difficult to know when you’ve found the right piece of literature,” she said.
“If they can accomplish a single model, it will be a huge positive,” Triplett continued. “It will be principles-based, which allows for more judgment, although some might argue that is both good and bad. There will also be a need for increased disclosures to provide users with the information they need to analyze the information that is being presented.”
There are also drawbacks to the proposed standard. One is the challenge companies will face when attempting to recognize revenue from a service transaction. It is far more difficult to determine when control of a service transaction is transferred than it is for a tangible good.
Further, the concept of estimating the selling price of an individual element within a multi-element product or service is something many finance and accounting departments may not be equipped to do. This will be an issue for companies that are not in the scope of the amended guidance in EITF 08-1. Success will likely require going to the product people who are already setting prices to determine the best strategy.
Finally, some may peg the increase in judgment to be a distinct drawback to the proposed standard because of the inconsistency it creates.
“It’s a principle so it’s going to be applied by reasonable people differently. You might get different answers for what appear to be very similar transactions. There might be some initial lack of comparability. That exists with any new rule, but this covers revenue recognition and revenue is top line,” said Triplett.
Anticipate, Educate and Plan
When it comes to taking action, Triplett advises companies to at least begin evaluating the potential impact of the new standard.
“Don’t wait because you think this won’t affect you. Almost every organization will be impacted,” she said. “It’s just a function of how much impact there will be.”
The full breadth of challenges the new standards could create is not yet fully known. In addition to those challenges identified above, expectations are that the new rules may cause significant problems in terms of ERP and financial systems, most of which are not capable of processing transactions under the new revenue recognition method.
Further, it could force companies to re-examine commission structures and scale back on the education and earnings guidance provided to investors and analysts. Companies may also need to examine how they account for warranties and even make changes to long-accepted accounting practices.
Despite the multiple unknowns, Triplett warns companies not to wait for adoption before taking action. They should already be examining policies and procedures to identify any that might be impacted by the change in revenue recognition rules and begin planning any system or processes changes that may be necessary to accommodate them.
Also smart is meeting with audit committees and governance boards to discuss any changes that the new rule may necessitate. Finally, assign responsibility to someone to stay abreast of what is happening with the Exposure Draft to ensure there are no surprises down the road.
“People have a tendency to wait until something has been issued before focusing on it. I don’t think it would be prudent to wait to understand what the proposed rules are. Even if they change in re-deliberations, they might not change significantly,” said Triplett. “…The more familiar people can become with it now, the better it will be when the time comes to adopt it.”
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