New Revenue Recognition Standard Closing in on Manufacturers and Distributors
When it comes to revenue recognition, accounting principles generally accepted in the United States (GAAP) have been industry-specific and rules-based. For most manufacturing and distribution companies, the rules have been fairly simple. But as commerce becomes more global and countries use different standards of their own, revenue recognition has become increasingly disjointed.
To remedy this, U.S. and international accounting standard-setters have agreed on a new principles-based standard for consistent revenue recognition. The new standard’s core principle is “to depict the transfer of promised goods or services to customers in an amount that reflects the consideration expected to be received.”
By now you are probably familiar with the five steps outlined within this core principle:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
These steps are simple enough on the surface, but from a practical standpoint there are several considerations to factor in, including new definitions of “contract” and “performance obligation,” and the potential for new estimates and judgments required in each step.
Complexity of contracts dictates which companies are affected
If your company manufactures and sells products through simple distribution channels, you probably won’t be significantly impacted by the new standard. This is because your “contracts” are either very simple (such as a purchase order) or are nonexistent.
But if your company manufactures custom products or has complex contracts that include multiple deliverables or extend are over a long period of time, your accounting will probably become more challenging. You will need to be constantly aware of contract modifications; unpriced change orders, contract extensions, and sale of additional goods can require additional attention and affect both the timing and amount of revenue recognized. In some cases, contract modifications can result in a new contract from an accounting perspective, while in other cases they are accounted for as an extension of the existing contract. Each situation must be assessed and measured according to the five-step process.
Steps 2 and 5 are the most problematic for manufacturers
Of the five steps outlined in the core principal, steps 2 (identify the performance obligations) and 5 (recognize revenue when or as the entity satisfies a performance obligation) can be the most problematic for manufacturers. If a good or service is distinct or sold separately by your company, it is more than likely a separate performance obligation. But certain manufacturer warranties and shipping and handling costs need to be evaluated differently under step 2 in the new standard.
For example, a manufacturer of electric bikes sells directly to the end user. Included in the price of the bike are shipping and handling costs and a generous warranty, which provides for protection against certain defects in workmanship, as well as replacement of certain life-limited parts, including labor. In this scenario, how many performance obligations does the company have? Warranties with attributes similar to service-type activities are considered separate performance obligations, so the company would need to estimate what portion of the warranty would be accounted for as a loss contingency (defects in workmanship) and what portion would be service (life-limited parts replacement with labor). A portion of the sales price would need to be allocated to the service piece of the warranty. Shipping and handling costs are generally not considered to be a separate performance obligation.
Additionally, some manufacturers recognize revenue on the percentage of completion basis or milestone method for long-term, production-based contracts. In assessing step 5, some variation of this practice may continue for manufacturers of custom products. Where there are no alternative uses or customers, and the manufacturer is entitled to payment during the manufacturing process, satisfaction of performance obligations and the resulting revenue recognition could occur over time while the custom product is being produced. In this case, the new standards likely result in no change to current revenue recognition practice.
Is it time to pull the accounting fire alarm?
If you haven’t yet evaluated how this standard might affect your company, now is the time to get to work. For privately owned companies with calendar year-ends, the standard is not effective until periods beginning after January 1, 2019 — but to comply with that date, you’ll need to know precisely how the timing and recognition of revenue (as well as certain related costs) will be presented in your comparative financial statements by the beginning of 2018.
There is also a significant number of new financial statement disclosures that may require additional time to prepare for, and existing billing and financial reporting systems related to revenue may need to be modified or replaced.
The first thing you must do is identify, understand, and organize your customer contracts by type, duration, geography, or some other disaggregated measurement. Then, on a contract-by-contract basis, assess the five implementation steps, document and record conclusions, identify issues or areas where revenue recognition could be changing or contracts might need to be modified, and develop a system of controls for recognizing the revenue.
Like most changes this can be easier said than done. This process often requires the involvement and input from several functional areas of your company other than finance and accounting, such as your sales, legal, and marketing departments.
How we can help
It is indeed time to pull the accounting fire alarm. You don’t need to panic, but the time for planning your implementation of this new standard is now. CLA’s manufacturing and distribution industry professionals can help your company evaluate your contracts with customers, document the evaluation process, and implement a system of controls and estimates used in recognizing the revenue from these contracts. While the new standard outlines a single comprehensive revenue recognition model, it is not a one-size-fits-all approach. In many cases it requires a higher degree of judgment and an increase in the use of estimates, and we can show your team how to effectively make those judgments.