ASC 606, Revenue from Contracts with Customers, is effective on January 1, 2019 for calendar year private entities.
Is Your Business Prepared?
The new revenue recognition model is a significant change from existing GAAP and will require internal resources to comprehend, analyze, document and comply. The remainder of this article is intended to point out some of the key considerations in helping you determine the impact on your manufacturing and distribution business. We urge you to read the context of ASC 606 as well as various resources identified throughout this article and work internally and with your accountants to ensure a smooth transition.
Under ASC 606, revenue is recognized upon the transfer of control, which is a significant difference from the risk-and-rewards model under current GAAP.
This new standard requires companies to follow a 5-step process:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue when or as the entity satisfies a performance obligation
Each step of the process contains complexities and will entail significant judgment and estimation on the part of your team. It is important to ensure you document your considerations along the way in order to support your unique revenue recognition policy. What follows are key considerations within each step.
Step 1: Identify the Contract with a Customer
This may seem like a simple task; however, this is a critical first step in the new revenue process. Identifying what constitutes a contract drives the remaining four steps as well as the disclosure requirements. Contracts may be constituted by purchase orders, supply agreements, invoices or other written, verbal or implied contract.
To be considered a contract, an agreement must meet the following criteria:
- Legally enforceable and approved by both parties
- Has commercial substance
- Rights to goods or services can be identified
- Payment terms can be identified and it is probable that consideration is collectable
If either party has a unilateral enforceable right to terminate an agreement without compensating the other party then a contract does not exist. Frequently this may be the case under Master Supply Agreements. In practice, we have noted in many instances that a contract does not exist until a purchase order is received.
It is critical to review all of your customer agreements taking into consideration the above noted items. The level of customization of these agreements may render this a time consuming task for both management and their CPAs. Agreements should be reviewed for termination clauses, specific production amounts/ schedules/ pricing and other performance obligations (as discussed below) that could indicate a contract exists.
Step 2: Identify the Performance Obligations in the Contract
Once you have identified a contract, the next step is to identify each performance obligation within that contract. Discussions with sales personnel and review of individual sales agreements will be key to identifying any such obligations.
A performance obligation is defined as “a promise in a contract with a customer to transfer a good or service to the customer.” Each performance obligation is considered to be a “unit-of-account” under the new standard and drives the ultimate recognition of revenue.
Promised goods or services (aside from the primary product) may include items such as training, support, maintenance services and other material rights. Product warranties will also need to be assessed for accounting treatment to determine whether they are assurance-type warranties or service-type warranties. Assurance-type warranties will be accounted for similar to current GAAP whereas service-type warranties are separate performance obligations and would likely require deferral. Warranty terms and provisions will also need to be reviewed.
Shipping and handling activities may also be considered a performance obligation, however, there is a practical expedient that can be elected allowing you to avoid allocating the transaction price to this activity.
Step 3: Determine the Transaction Price
On the surface, Step 3 is straightforward; however, ASC 606 may impact your accounting for rebate programs, discounts offered and any financing components.
Volume discounts are a common practice. We urge any entities that offer such discounts to review this article from RevenueHub. The accounting for discounts and rebate programs can be complex and management should review all agreements to inventory such programs and assess the impact of ASC 606.
Contracts should also be reviewed for any significant financing components and how that may impact the transaction price (taking into consideration the time value of money). There are many practical expedients allowed under ASC 606, one of which allows companies to only consider arrangements where payment is expected in excess of one year from contract inception.
Step 4: Allocate the Transaction Price
The transaction price determined in Step 3 must be allocated to each performance obligation identified (if more than one). Allocation should be made based on the relative standalone selling price of each performance obligation. There are several options to estimate the standalone selling price. You should use the method that best suits your circumstances.
Areas that may cause complexities include:
- Allocating any variable consideration to the respective performance obligations
- Estimating the standalone selling price when it is not directly observable
Consult the guidance and your accountant in working through any complexities in this area.
Step 5: Recognize Revenue When or as the Entity Satisfies a Performance Obligation
The final step deals with the timing of revenue recognition for each performance obligation. The new guidance requires you to assess whether the recognition occurs at either a point in time (i.e. shipment) or over time.
A performance obligation is satisfied over time if one of the following criteria are met:
- Customer simultaneously receives and consumes the benefits as the company performs its obligations (i.e. sale/delivery of electricity)
- The Company’s performance creates an asset that the customer controls as the asset is created (i.e. building a house).
- The Company’s performance does not create an asset with an alternative use to the Company and the Company has an enforceable right to payment for performance completed to date.
Let’s explore that last bullet a bit more as it can have a significant impact in the way in which manufacturers recognize revenue and inventory.
Assume you are manufacturing a product specific for a customer and you do not have the ability to readily divert that product elsewhere. Now assume you also have an “enforceable right to payment” for progress performed to date. Based on the above, you would qualify for recognizing revenue over time (as the product is being manufactured), resulting in accelerated revenue recognition and a decline in inventory.
Understanding the definition of an enforceable right to payment is critical to this process and may include some judgement as well as consultation with your attorney and CPA. An enforceable right to payment exists if the Company would be entitled to payment of incurred costs, plus a reasonable profit margin, on the work performed to date if the customer were to early terminate the contract. We urge management to begin to look at their contracts and the interpretive guidance as soon as possible for any such provisions.
If none of the above indicators are met, an entity will recognize revenue at a point in time, likely in line with how revenue is currently being recognized.
Other Areas of Consideration
ASC 606 should also be reviewed for considerations specific to:
Under ASC 606, the criteria for bill-and-hold arrangements permit recognition of revenue when control of the goods transfer to the customer. The arrangement is not required to be at the customer’s request, just a substantive arrangement. No specific delivery date is needed, however if a delivery date does not exist, the enforceable rights of the parties may need to be evaluated to see if a contract exists. Additionally, the company must evaluate if the obligation to warehouse the goods after control has transferred represents a separate performance obligation.
The accounting for consignment arrangements did not significantly change.
Principal vs. agent considerations
A company must consider if it is acting as a principal or an agent when delivering goods to a customer as this will impact whether revenue is recognized on a gross or net basis. Having primary responsibility to provide the goods, assuming inventory risk, and having the ability to establish prices are indicators that an entity is acting as a principal and should account for these transactions on a gross basis.
Costs of obtaining a contract
Under the new guidance, costs incurred as a result of obtaining a contract that are expected to be recovered must be capitalized. The most common example in manufacturers and distributors would be sales commissions. However, the company may elect a practical expedient for which they can expense all of these costs in the period they were incurred, as long as the period of the contract is initially expected to be less than one year. If the expedient is not elected, the costs must be capitalized and expensed over the life of the contract.
For contract modifications, you must consider if the modified contract is for additional goods and services that are distinct AND at their standalone selling price. If so, account for the new goods or services as a separate contract. If not, you must assess if the remaining goods and services are distinct from those in the original contract and refer to ASC 606-10-25-12 and 13 for how to treat each scenario.
Initial Adoption Considerations
There are two options for adopting ASC 606, the full retrospective method and the modified retrospective method. The difference in the methods comes down to the prior year’s presentation of revenue and related line items on the balance sheet and income statement. We expect that most companies will use the modified retrospective approach and record any initial adjustments through retained earnings on the first day of adoption. The full retrospective approach would require the company to recast the financial statements for each of the prior two years.
There is transitional guidance applicable to completed contracts and contract modifications that occurred prior to the initial adoption date.
Additionally, there are significant new disclosure requirements that will be required in the year of adoption, however there is private company relief from some of the disclosures.
This new standard added many new concepts and complexities that requires significant time and resources. The key takeaway is to begin assessing the impact of this standard now: 1) review your agreements, 2) document your considerations of each step in the process and 3) work internally and with your CPA firm to ensure you are prepared.