Your business's revenue is a significant benchmark that drives other major metrics, like net income, EBITDA1 , and earnings per share. But soon, how you recognize revenue may change, and the impact could ripple through your business.
After much deliberation, the FASB2 and IASB3 (the Boards) are set to release a final standard, part of the move toward a single set of global accounting standards. Companies in all industries and countries will use a new five-step model to recognize revenue from customer contracts. The intent is greater consistency and comparability throughout the global capital markets and across industries.
While the 2017 effective date may seem far off, proper preparation is essential. Revenue recognition is a critical accounting area, and your company can't afford to get it wrong. Your board and investors want to know what to expect, so get started now.
With the move to the new model, companies that currently follow industry-specific guidance may feel a considerable impact.
Revenue is measured based on the transaction price—how much the customer promises to pay in exchange for goods or services. The transaction price is simple to determine when it's a fixed amount at the time of sale. It's more complicated if the amount could vary in the future based on contract terms.
Here's how businesses in four industries might feel the effects of the new standard:
Companies that license intellectual property (IP), like music or movies, will need to determine if they are providing a right to use the IP or access to the IP. If providing a right to use the IP, which transfers at a point in time, revenue is recognized when that right transfers to the customer. Licenses that provide access to the IP are performance obligations that are satisfied over time and, therefore, revenue is recognized over time. Determining which type of license companies provide could be challenging, especially if they enter into unique arrangements rather than standardized agreements—each of which they'll need to analyze.
Today, software companies have very prescriptive rules that may result in delayed revenue recognition. Over time, some business practices evolved as a result of the rules to include renewal rates in contracts, limit discounts offered to customers, and not provide promises to future software. Under the new model these rules are eliminated, so companies can rethink the nature of their contracts and how they negotiate terms with customers.
The telecom industry often provides multiple products and services to their customers as part of a bundled offering. Currently, specific guidance limits the amount of revenue allocated to the delivered item (for example, a handset). But the new standard requires revenue to be recognized in proportion to the standalone selling price of each good or service provided. This may result in a significant change in the timing of when revenue is recognized in telecom handsets and service arrangements.
The real estate industry currently has guidance providing specific models for recognizing revenue in different situations. But the new standard replaces this. In many circumstances, these changes could result in a significant shift in when revenue is recognized. Revenue could be recorded earlier than under today's standards in some situations.
Here are a few examples of areas where you'll need to make subjective assessments for the new standard. Management should document their basis and rationale for these key judgments and estimates.
In the new standard, time value of money will play a factor.
When a contract contains a significant financing component, the transaction price is affected by the time value of money. So companies that have contracts with a significant financing component may face operational challenges associated with measuring and tracking time value of money if they don't do this today.
What's "significant"? Determining when a significant financing component exists could require considerable judgment. For example, a software company provides three years of customer support for $300. The customer chooses to pay $300 upfront, in lieu of paying $100 per year annually. Is this a significant financing because the customer paid upfront? Or does the fact that the annual price was the same imply there is no financing? While the standard will provide relief in certain areas, it might be difficult in other situations to determine if a significant financing element exists.
There's now an array of fees that you may need to recognize sooner. Variable fees like performance bonuses and other forms of contingent consideration can be a significant portion of revenues for certain industries, like aerospace and defense, engineering and construction, asset management, pharmaceutical and life sciences, technology, and entertainment and media.
In the past, many businesses had to delay revenue recognition for variable fees until they were received or earned. Under the new model, if a company can point to experience with similar arrangements, revenue may be recorded earlier than today.
This may result in the need for new processes to estimate variable amounts and to then revisit these estimates each reporting period.
Licensors may be greatly affected. Licenses allow a customer to use a company's IP, such as its technology, media, patents, trademarks,or copyrights. The model for recording revenue on licenses will depend on whether the license provides a right to use IP, or access to IP.
The type of license will depend on whether the IP is"dynamic" or "static." A dynamic license is one where the provider of the IP continues to undertake activities related to the IP, and the customer is exposed to the effects of that activity. For example, a license to place a famous sports team brand on T-shirts might be dynamic, as the sales of T-shirts (and therefore the value of the license) could be impacted depending on the team's performance. In contrast, a static license provides the customer with access to IP that does not change after the license transfers to the customer(e.g., purchasing a license to download the content for a textbook).
Your financial reporting isn't the only thing that will change with the new standard. Here are four areas where you'll need to consider the effects on your business.
When the new rules take effect in 2017, a larger portion of some companies' revenue will be based on estimates. For example, accounting for variable consideration and reflecting the time value of money, among others, could increase the use of estimates. These estimates won't come easily for companies not accustomed to making them and might require you to collect and analyze more data than in the past.
So consider if your systems, processes, and internal controls are up to the task. Current systems might not be ready to capture and process the data needed for forming and monitoring new estimates, and for tracking revenue differences for book and tax purposes. There are also significant new disclosures that will be required that current systems might not be ready to capture. And existing processes may need to be reviewed to ensure the applicable internal controls are in place to apply the new standard.
Contract terms and strategies that are required for existing revenue accounting may no longer be advantageous or necessary under the new standard. Applying the new model gives you the chance to take a fresh look at how you do business. For example, look at business practices that might have been influenced by the existing revenue rules. Contract terms included to address today's
bright-line requirements might not be needed
under the new model.
Many existing financial arrangements may need re-examining. For instance, many companies will want to look at factors that determine their bonus plans and other compensation agreements, which are often based on amounts derived from revenue. While contracts might remain the same, the fact that some companies may record their revenue in one period rather than ratably over several periods could result in more volatility and less predictability in employees' bonuses.
Similarly, debt covenants are often based on a measure of net income, the timing of which could change based on the new standard. Companies may unintentionally violate a debt covenant if their metrics or results change and they haven't amended debt agreements in preparation. You'll need to assess these types of arrangements in your business to see if they'll be impacted; inventory those that are; and measure the effect of the changes. You may need to modify some agreement terms to maintain their original intent.
Your business can't change its strategy and practices overnight. You'll need to consider the impact well in advance of the deadline for adopting the new standard.
Before diving into the financial-reporting implications—which can be significant—consider the strategic ones. This means looking across the business, which could require input from business unit heads, operations, sales, legal, talent, finance, tax, and IT. This team can evaluate how revenue recognition affects each function and the business as a whole.
Review existing revenue arrangements, contract terms, and business practices to identify where changes might occur: Will you have to rethink customer negotiations? What might compensation and benefit plans look like now? Should you rethink how you sell your products? What do you need to communicate to your investors, and when? Are there business opportunities resulting from increased flexibility?
You can evaluate the financial impact with forecasting models to predict changes in key financial measures, significant sales transactions, or a sample of transaction types. You should also consider assessing tax implications, as a change in timing of revenue recognition could accelerate cash tax liabilities.
Companies can choose how they want to adopt the new standard. One way is by recasting previous-period financial statements as if the guidance had always existed, which may require a lot of time and effort. Because redoing accounting for the prior comparable periods is a big undertaking, the Boards agreed to offer another option.
Companies can instead take their current-year numbers, in the year of adoption, and show them under both the new and old model. For example, this method requires presenting the 2017 financial statements under the new guidance, but including a footnote disclosure of all financial statement line items and the amounts they would have been under legacy guidance for 2017. This method offers a simpler alternative, but it isn't without challenges.
Transition could be especially difficult for organizations with multi-year contracts. Start record keeping soon if retroactive transition is a consideration.
Do a cost-benefit analysis: Do you have the resources at hand to do one method more effectively than the other? Is there a benefit to your business in having comparability between the before-and-after? What do your investors expect? What are your competitors doing?
Your stakeholders want to know about more than just your financials. Integrated reporting seeks to provide them with additional information about company strategy and risk, including environmental, social, and governance issues. But investors aren't the only ones who benefit; those organizations that adopt integrated reporting realize benefits throughout the business because they're thinking and acting as one, instead of in functional silos.
Access a PDF copy of the article on PwC.com.
To have a deeper discussion about the change in revenue accounting standards, please contact:
Jim Kaiser
Partner, US Convergence & IFRS Leader
(267) 330 2045
james.kaiser@us.pwc.com
Jon Gochoco
Partner, National Accounting Services Group
(973) 236 4110
jon.gochoco @us.pwc.com
Brett Cohen
Partner, National Accounting Services Group
(973) 236 7201
brett.cohen @us.pwc.com
Dusty Stallings
Partner, National Accounting Services Group
(973) 236 4062
dusty.stallings@us.pwc.com
Chad Kokenge
Partner, Transaction Services
(646) 471 4684
chad.a.kokenge@us.pwc.com
Chris Smith
Partner, Transaction Services
(408) 817 5784
christopher.j.smith@us.pwc.com
Catherine Benjamin
Director, National Accounting Services Group
(973) 236 4568
catherine.benjamin@us.pwc.com
Michelle Mulvey
Senior Manager, National Accounting Services Group
(973) 236 7272
michelle.l.mulvey@us.pwc.com
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