ASC 606 is coming, are you ready?
Jointly defined by the Financial Accounting Standards Board, the board primarily responsible for US GAAP, and the International Accounting Standards Board, the board primarily responsible for IFRS, the new revenue standards, redefine how revenue from contracts with customers needs to be managed.
The accounting standards have now converged and revenue recognition will change from being industry-specific and rules-based to being industry-agnostic and principles based. Most ERP vendors and major accounting firms agree that the new standards represent the largest accounting standard change in over a decade.
- Step one, identify the contract with a customer. There are specific guidelines to help determine if and when a contract actually exists between a vendor and a customer.
- Step two, identify the performance obligations in the contract. Here’s where we start to diverge from the existing standards – a performance obligation is defined as a promise to transfer a good or service. A performance obligation can be explicitly stated in the contract or it can be implied.
- Step three, determine the transaction price. The transaction price is the amount of consideration the entity expects to be entitled to, in exchange for transferring promised goods or services. For simple fixed price contracts, this will be relatively straightforward. However, for more complex contracts such as those with variable consideration this step can become more difficult. For software and high tech companies, this step essentially eliminates the VSOE, TPE and ESP methods of determining the transaction price.
- Step four, allocate the transaction price. The transaction price should be allocated to the performance obligations based on the relative standalone selling price. The standalone selling price is the price at which an entity would sell a good or service separately to a customer. It essentially eliminates the impact of deep discounts tied to specific performance obligations by reallocating the total contract amount to the various performance obligations based on their standard prices and discount levels.
- Step five, recognize revenue as you satisfy a performance obligation. Revenue allocated to a performance obligation should be recognized when the goods or services are transferred to the customer, which occurs when the customer has control of the asset or use of the service.
Obero’s partner, Intacct, conducted a survey targeted to finance executives to help them better understand the biggest challenges expected to be introduced by the new revenue standards. They found that challenges to be:
- Managing the variable elements of contracts from a revenue recognition standpoint
- Dual reporting during the transition phase
- Accounting for the costs to obtain and fulfill customer contracts
Dual reporting will be critical during the transition as it will need to be gradual. There are two options for reporting the impact, a full retrospective approach or a modified approach. We recommend you work with your auditors to review the pros and cons of each approach before adopting a methodology.
The new standards have changed the way the incremental costs of obtaining a contract with a customer are accounted for. The applicable costs are the ones that would not have been incurred had the contract not been obtained, which most commonly refers to sales commissions. Under the current standards, these costs can be expensed and recognized immediately, however under the new standards, they should be recognized as an asset and amortized over the duration of the customer relationship.
This might not sound too difficult right off the bat, but as the volume and complexity of the contracts increases, managing this process becomes much harder.
To make life a bit easier, the guidance includes a practical expedient which allows the incremental costs to be expensed as incurred if the associated contract is one year or less in duration. This definitely helps, but in most cases customer relationships will extend beyond one year, so this practical expedient won’t always be leveraged.
Now join this process with the revenue recognition process to get a sense for how the financial close process will change from the perspective of accounting for incentive compensation.
Overall, the major steps tied to the financial close process will remain the same, but each of the steps will be augmented to accommodate the new requirements.
The process starts by recording all of the contracts and managing the performance obligations, which typically triggers commission earnings. As an example, for software companies it’s common for reps to earn commissions tied to recurring revenue streams, such as subscriptions, at the time the contracts close, but they typically only earn commissions on non-recurring revenue streams, such as professional services, when the associated revenue is recognized for those performance obligations.
The next step is to manage the balance sheet. It’s typical for commissions to be held until a customer pays the invoices tied to contracts. When the invoices are paid, the commissions are typically released and the associated accruals are reversed. During this step you also need to capitalize the commissions tied to your existing and future contracts.
From there, you have to manage the income statement where we would typically leverage the revenue recognition schedules from the contracts to drive the amortization of the capitalized commissions. You also need to determine the commissions that are technically prepaid or fully recognized.
At that point you can prepare the financial statements across both standards factoring in the treatment tied to any contract adjustments.
And finally, during the transition period a company can model out the profitability impact of the different accounting treatment options afforded to them to make strategic decisions. The key though is to ensure that these key decisions are properly disclosed as the disclosure requirements are quite extensive under the new rules.