Effective for your fiscal years beginning after December 15, 2018, all non-public entities will need to implement the new revenue recognition standards as outlined in Accounting Standards Update 2014-09 Revenue from Contracts with Customers (Topic 606) (ASU 2014-09). The standard requires all companies to take a look at their revenue recognition, measurement of revenue, financial statement disclosures, systems, processes and internal controls to ensure they are in compliance with this new standard. The AICPA has created sixteen different task forces to help various industries which are heavily impacted by this standard; however, one industry left off is the manufacturing and distribution industry (M&D). Since there is no specific task force or guidance for the M&D industry it is more important for management to read and understand this standard and work with their CPA and legal counsel to ensure they are following the standard accordingly. The following is a brief overview of the standard that should be shared with the management of the company.
Under the current standard, a typical company in the M&D industry will recognize revenue once risks have been transferred to the customer (i.e. the point of sale). The new standard will require companies to consider if the provided good or service is under customer control and transferred over a period of time. If it is determined that control is transferred over a period of time, revenue will need to be recognized over that period of time. It is important to also point out that under the new standard, any variable considerations within a contract, such as rebates, refunds, volume discounts, etc. will need to be allocated along with the revenue recognition over the period of time. If your company has any of the three following situations, revenue recognition over time will likely be required:
1. Customer simultaneously receives and consumes the benefits provided by the manufacturer as it performs;
2. The manufacturer’s performance creates or enhances an asset that the customer controls as it is created or enhanced;
3. The manufacturer’s performance of the contract does not create an asset with an alternative use to the manufacturer and the manufacturer has an enforceable right to payment for the performance completed to date.
All companies should go through the 5 step process explained in the standard, which will ensure that they are, identifying each contract, identifying the transfer of promised goods or services to customers within those contracts, and recognizing revenue in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
The 5 steps are:
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
While all the steps listed in the standard are important to read, understand and follow, steps 1 and 2 are the most important. Within these steps, management will identify their various contracts and the promises to transfer a good or service to the customer.
Under step 1 management will need to identify all the contacts with customers. Before you can do this a company will need to ensure that they understand the definition of a contract as stated in ASU 2014-09. The standard states that “A contract is an agreement between two or more parties that creates enforceable rights and obligations.” A contract can be written, oral, or implied by an entity’s customary business practices. A contract also needs to meet the following criteria; to include the approval and commitment of all parties involved, identify the rights of the parties, identify the payment terms, to have commercial substance, and to be probable that the company will collect the consideration for which they are entitled in exchange for the goods or services transferred. If these criteria are not within the terms of the contract, revenue cannot be recognized until; (1) there are no remaining obligations and substantially all consideration has been received and is non-refundable, or (2) the contract has been terminated and consideration received is non-refundable, or (3) the control of the goods or service has been transferred and consideration for those items transferred has been received and is non-refundable. As you are reading and identifying contracts it may be helpful to note that per the Uniform Commercial Code, $500 is the threshold for an oral agreement to be in writing to be legally enforceable.
Under step 2 you will need to identify the performance obligations in the contract. The standard defines a performance obligation as “a promise in a contract with a customer to transfer a good or service to the customer. If an entity promises in a contract to transfer more than one good or service to the customer, the entity should account for each promised good or service as a performance obligation only if it is (1) distinct or (2) a series of distinct goods or services that are substantially the same and have the same pattern of transfer.” On a contract by contract basis management will need to determine whether a contract contains one or several performance obligations. This step could be difficult for the M&D industry to apply due to the fact that M&D companies could have numerous contracts with a customer. M&D companies could also run into issues measuring the performance obligation for work in process items and determining what the enforceable rights for payment are. There could be a considerable amount of judgement in management’s assessment of when to recognize revenue. The complexity of going through each contract to determine the various performance obligations to recognize revenue over time could be cumbersome and costly. Here is where the advice of a CPA with expertise on how to apply these standards is most valuable. Management will know best what the company is capable of but the CPA can assist by informing what will comply with the standard and how best to get the internal reporting for this transition.
Once a company has step 1 and 2 completed the remaining steps should be applied to then be able to recognize the revenue over the life of a contract in accordance with the standard. Going through these steps a company will gain an understanding of how important it will be for them to have strong internal controls over the contracts the company enters into. Since there is no task force dedicated to the M&D industry there could be more exposure and judgement when it comes to recognizing revenue.
As mentioned earlier, the standard has also changed and expanded the required financial statement disclosures as it relates to revenue recognition. Some of the additional disclosures include qualitative and quantitative information. The information for the required disclosures could take time to gather and prepare, therefore, it makes sense to start thinking about the impact to your annual statements now so there will not be a delay during your audit or review later.
Many companies in the M&D industry will be facing a tough uphill battle implementing this new standard. Don’t find yourself one of them. If you have questions or need assistance with implementation of this standard in your company, please contact the A&A department of MKS&H.
Article Contributed by Megan Baker, CPA.