By Jon Sutter
The new revenue recognition standard is upon us, and many manufacturing companies are wondering what impact the new rules will have on their financial statements. Rarely a week goes by without someone asking our team for help explaining the changes and their potential impact. We often hear the misconceived view that the new standard only affects large, complex companies with long-term contracts. Those with this view commonly ask, “What quick changes should our organization undertake to be in compliance with this new standard?” Unfortunately, it’s usually not that simple.
The new standard, Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, introduces a new core principle that requires organizations to approach revenue recognition in a new way. The focus of ASC 606 is on the transfer of control, and it requires more judgment and estimation, which is a meaningful change from the risk-and-reward model prescribed by ASC 605 (“legacy GAAP”). This new core principle requires that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that they expect to be entitled to in exchange.
ASC 606 provides a five-step framework for organizations to determine the amount and timing of revenue recognition:
- Identify the contract(s) with the customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
While the steps may seem fairly straightforward, there are complex considerations that need to be evaluated for each step. The five-step model may result in meaningful differences from legacy GAAP, but the impact for a given manufacturer will ultimately depend on the entity’s specific products and services and the specifics of its contracting practices.
Key Considerations for Manufacturers
Manufacturing companies have a number of key provisions to consider under the new standard. These include:
- Timing of revenue recognition: The new standard focuses on the transfer of control, with revenue recognized as the goods or services underlying a performance obligation are transferred to the customer. This new model differs from the risk-and-reward model generally prescribed by legacy GAAP.
At contract inception, companies must now determine if control transfers over time based on specific criteria in the new standard. Control transfers over time if the product manufactured for the customer does not have an “alternative use to the entity” and the entity has an “enforceable right to payment” for performance completed to date. If this criterion is achieved, the related revenue must be recognized over time in a manner similar to the percentage of completion method in legacy GAAP.
By way of illustration, consider a manufacturer that receives a purchase order (contract) to manufacture 1,000 units of a customized widget that has no alternative use because there is only one potential customer for the widgets or the terms of contract prohibit the manufacturer from selling the widgets to another customer. Consider further that the contract grants the manufacturer an enforceable right to payment for work already performed in the event the customer cancels the contract. In this scenario, the manufacturer would likely be required to recognize revenue over time during the production process. Under legacy GAAP, the manufacturer would likely only have recognized revenue upon shipment and transfer of legal title. If none of the “over time” criteria are met, revenue must be recognized at a point in time based on when the customer obtains control of the goods or services. The new standard provides a listing of factors that indicate that control has been transferred. However, the factors provided are not all-encompassing, and there will be situations where companies will have to use judgment in evaluating when control has transferred.
- Bill-and-hold arrangements: Under the new standard, there’s no longer a requirement for a specified delivery schedule or an explicit customer request in order to recognize revenue. This change will result in situations where revenue is recognized earlier than under legacy GAAP. As described above, the new standard focuses on when control of the goods transfers to the customer. This approach differs from the current SEC guidance (SAB 104) for bill-and-hold arrangements. Additionally, under the new standard, an obligation to warehouse the goods after control has transferred to the customer will likely result in a separate performance obligation. In this situation, recognition of revenue associated with the storage service would likely be later than under legacy GAAP.
- Warranties: Manufacturing entities often provide warranties that guarantee the company’s product meets the promised specifications. The new standard distinguishes between two types of warranties: “assurance-type” (i.e., a promise to repair or replace a product if it does not perform to specifications) and “service-type” (i.e., a promise to provide service beyond the assurance that the product will perform to specifications). Under legacy GAAP, generally only separately priced warranties are considered separate deliverables for accounting purposes. Under the new standard, a warranty is a separate performance obligation if it offers a service beyond assuring that the product will perform to specifications.
To determine if a warranty includes a service (in addition to the assurance component), the new standard includes certain factors to consider, including: whether the warranty is required by law, the length of the warranty coverage period, and the nature of the tasks promised to be performed. For example, consider a company offers customers a standard 18-month warranty on its products, which is considered the “industry standard.” However, certain customers are granted a 60-month warranty for no additional consideration. In this situation, it’s likely that the 60-month agreement includes both an assurance-type (first 18 months) and a service-type (the last 42 months) warranty. Any service-type warranty would need to be recorded as a separate performance obligation and subsequently recognized as revenue because control of the promised service is transferred to the customer.
- Disclosures: The new standard requires expanded disclosures (both qualitative and quantitative) compared to legacy GAAP in order to make it easier for financial statements users to understand the nature, amount, timing, and uncertainty of revenues and cash flows. While the disclosure requirements are less expansive for nonpublic entities, they’ll still be required to disclose more than they have in the past, including information on customer contracts, revenue categories, contract balances, performance obligations, and significant judgments.
The above points capture some, but not all, of the issues that manufacturing companies need to consider. Other considerations include significant financing components, variable consideration, costs to obtain a contract, series of distinct goods, and contract combinations.
Nonpublic entities are required to adopt the new standard for annual reporting periods beginning after December 15, 2018. For the vast majority of nonpublic entities, this means the new standard is effective for the 2019 calendar year. Meanwhile, for nonpublic entities that report under IFRS, there‘s a similar new revenue recognition standard (IFRS 15) that is effective for periods beginning on or after January 1, 2018.
ASC 606 permits a choice from two transition methods: (1) full retrospective and (2) modified retrospective. The full retrospective method requires all periods presented to be restated, with a cumulative effect adjustment to equity as of the earliest period presented. The modified retrospective method, on the other hand, requires the entity to restate as of the beginning of year of adoption with a cumulative effect adjustment to that period’s beginning equity. Most companies are using the modified retrospective method of adoption; however, that may not be the best method for your company.
Regardless of the method used, it is important to have an adoption plan in place that allows for timely and accurate implementation. It is also crucial that key stakeholders understand the basics of the new rules so they can gain an analytical understanding of likely financial statement changes and assess the need for possible modifications to contracting practices going forward. A good adoption plan should include these elements:
- Identification of an implementation team to own the process.
- Evaluation of all key contracts and revenue streams.
- Election of the best method of adoption, whether the full retrospective method or the modified retrospective method.
- Education of, and communication with, key stakeholders (including owners, lenders, boards, and others).
We can help
Jon Sutter is located in the Greenville, South Carolina office of Elliott Davis and has more than 10 years of experience providing assurance and consultative service to clients in the manufacturing industry. If you need assistance or have any questions, please contact him at email@example.com.