Key considerations for Middle Market Companies
Revenue recognition accounting standards drastically changed for middle market nonpublic businesses, effective January 1, 2019, for those with a calendar year-end. Financial leaders of many companies may be asking “What do we need to do to comply with these changes, and how do we get there?” Although the effective date has now passed, it’s still not too late for companies to assess the impacts of the new accounting rules and develop a game plan for implementation of this new revenue recognition model.
There are likely to be changes needed in the following areas for companies in implementing the new standard: accounting processes and internal controls, customer contract review, cross-functional coordination between the sales and accounting departments, and capturing relevant information needed for expanded financial statement footnote disclosures.
Key points of the new Revenue Recognition standard:
Under the new accounting standard, Revenue from Contracts with Customers (Topic 606), companies are now required to recognize revenue under a five-step process.
- Identify the contract with a 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 performance obligations are satisfied.
A key concept of the new standard is to recognize revenue when control of a promised asset or service is transferred to the customer. “Control” refers to the customer’s ability to direct the use of and obtain substantially the remaining benefits from an asset or services. This control can occur at a point in time or over time and is a significant shift from previous accounting rules in which revenue was typically recognized upon delivery of a good or service.
The timing of when control transfers to the customer could result in revenue being recognized sooner for some companies than in current practice, which could positively affect the bottom line. This determination process will require more judgment than in the past to assess whether the control is transferred before delivery of a good or service occurs.
Specific Revenue Recognition areas of concern for middle market companies:
There are several key areas that this new standard will impact many middle market companies. Below are some of those and the unique considerations for each.
Under the new revenue standard, companies that produce highly customized products could be able to recognize a portion of revenue during production. For companies to recognize revenue over a period of time rather than at a point in time, the product would have to be customized to the point that it does not have an alternative use and could not be sold to another customer. The company must also have an enforceable right to payment of cost plus a margin to be able to recognize revenue during the production process. Simply having a right to recover costs to date with no profit built in would disqualify the revenue from being recorded over time.
The previous revenue standard did not allow recognition of any revenue on a customized product until production is completed and the risks and rewards of owning the product have been transferred to the customer. Topic 606 requires sales contracts for customized products that qualify for over time recognition of revenue to be measured using either an input method or output method. This choice of method determines how much revenue should be recognized during the production process.
Shipments via common carrier:
Traditionally, most companies have shipping terms with customers under Free on Board (FOB) shipping point or FOB destination (delivery point) and record revenue based on those terms. Now companies are required to assess when the customer takes control of the goods and record revenue at that point in time. For example, if a company ships goods to a customer’s warehouse in Dallas under FOB delivery terms, but the customer can elect to change the delivery point to its warehouse in Kansas City while the goods are still in transit, then control has passed to the customer when it leaves the vendor’s facility. The company should, therefore, record revenue when it ships the product, even though the shipping terms are FOB delivery point.
In instances where a company ships product under FOB shipping point terms, but also covers any damages to the goods while in transit, there are two distinct performance obligations: (1) sale of the goods, and (2) insurance on the product while it is in transit. The new revenue standard requires that the sales price be allocated to the two performance obligations and recorded at different points in time.
Companies will need to assess the impacts of this to determine if there is any material effect on the timing of recording revenue at the end of a reporting period.
Bill and hold arrangements:
Following the new five-step process for revenue recognition, there are two distinct performance obligations under a bill-and-hold arrangement, the sale of the goods and the warehousing or storage of the goods. Companies with these contracts must allocate the sales price to these obligations as they are performed. It will be necessary to determine when control transfers to the customer and record the sale at that point, then record the allocated warehousing revenue portion over time as it is held in the company’s facility.
Volume discounts and rebates:
Volume discounts and rebates are attributed to be variable consideration under the new revenue accounting guidance. Companies should include an estimate of the variable consideration in the transaction price at the time the revenue is recognized provided it is probable that a significant revenue reversal will not occur. The previous revenue guidance required volume discounts and rebates to be recorded as they were earned by the customer.
Both volume discounts and volume rebates could result in the creation of contract assets and contract liabilities to be recorded as the portion of the estimated discounts or rebates are recorded at the time of the sale.
Warranties are directly impacted by the new revenue model and fall into one of two categories: (1) assurance warranties (the product will function as the parties intended), and (2) service warranties (additional benefits that are not part of the agreed-upon specifications). Companies will be required to determine if separate performance obligations result from the warranty offered, which may require allocation of the sale price and recording revenue at differing times.
If there is an option to purchase the warranty separate from the transaction (e.g. extended warranty), it is always considered to be a separate performance obligation. In situations where the warranty is part of the original purchase, companies must determine if it is an assurance type warranty or a service type warranty.
Most assurance type warranties would not be considered a separate performance obligation under topic 606, but would rather be accounted for as a guarantee, whereby the company simply records the sale at full transaction price and estimates any future warranty expense as a liability on its balance sheet. There is no change from previous accounting requirements for assurance type warranties.
However, service type warranties should be treated as separate performance obligations and companies must allocate the transaction price to the sale of the product and service type warranty. An example of this is when an automobile dealer sells a new car for $40,000 with 24 months of free maintenance. Assuming the implied stand-alone selling price of the maintenance service warranty is $2,000, the dealer would record the $38,000 revenue for the car on the date of sale and would record the $2,000 revenue allocated to the service warranty over the 24-month maintenance period.
There are significant changes required under the new revenue recognition accounting standard that is effective for calendar years beginning January 1, 2019. But there is still time for companies to develop an assessment of its impacts and determine what changes need to be made to ensure compliance.
Companies need to revise processes and controls where needed to properly account for these changes and should work with a qualified Certified Public Accountant (CPA) during the process of assessment and implementation of the new revenue recognition standard to ensure compliance.
All businesses are required to fully assess the potential changes on the new standard on their revenue streams.
The clock is ticking and the sooner a full plan for implementation is developed, the less pain and disruption companies will experience.
For more information or to see if these changes will impact you, contact us.
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