Revenue Recognition Is Here: Are You Ready?
Mark A. Thomson
Non-public manufacturers and distributors are affected by the 2019 GAAP change in how revenue is recognized. Have you made changes already? Do you understand how your financial statements will be modified for 2019? Have you discussed this with your bank?
Industry information collected indicates that most companies and firms are still struggling with understanding and implementing these major changes, even though we are more than halfway into the year. The biggest change is that billing and recognizing revenue are no longer connected, which is a confusing concept. To help you move forward with your company’s implementation, it is important to understand some new keywords and phrases:
An agreement by both parties, written or oral, to perform their respective obligations with enforceable rights. These obligations must be identifiable with payment terms and have commercial substance. Finally, the entity must expect, with a high degree of certainty, to collect the final amount due.
- Performance Obligation
A promise in a contract with a customer to transfer a good or service to the customer. Each contract may have one or more performance obligations.
- Transaction Price
An amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services.
- Variable Consideration
An amount that will affect the net consideration received for performance of this obligation.
Recognizing revenue has become a five-step process. Based on each transaction, an assessment must be made to:
- Determine if there is a contract with a customer;
- Identify the performance obligations in the contract;
- Determine the transaction price;
- Allocate the transaction price; and
- Recognize revenue when the performance obligation is satisfied.
Let’s walk through a simple example for a manufacturer:
- Is There a Contract?
Typically with a manufacturer, the contract will be the company’s obligation to make a product and deliver it to a customer by a certain date, and the customer’s obligation is to take ownership of that item and pay the company for the goods received. The company typically documents this by generating an invoice with payment terms, and the customer usually initiates the contract by issuing a purchase order (“PO”). At this time, the company must determine if they will be able to collect from this customer. If there isn’t more than a 70% likelihood of collection, then there may not be a contract and revenue cannot be recognized until the payment is received.
- Now That There is a Contract, What are the Company’s Performance Obligations in the Contract?
The company will make an inventory item that the customer wants (more than likely based on the customer’s PO). The company will deliver the goods on a certain date, and based on the shipping terms, i.e. Freight on Board (“FOB”) shipping point, the goods’ ownership transfers to the customer.
- What Is the Transaction Price?
Now, this is where things become more complicated for the typical manufacturer, since there are usually several variable considerations which will reduce the transaction price. These include payment term discounts, volume rebates, credits for free goods, the ability to return goods, slotting fees, credits for advertising allowances and other advertising programs. Each of these situations needs to be assessed with each contract based on the specific customer experience and history. In the past, companies would recognize revenue based on the full amount of the item invoiced and then accrue for various allowances and discounts which were part of the reduction of gross sales or included as part of selling expenses. These variable considerations need to be estimated and then applied against the original item invoice amount to arrive at a net transaction price in order to recognize the correct amount of revenue. This is where several changes will occur:• Income statements will no longer show gross revenue with various reductions to arrive at a net revenue number. Only the net revenue number will be shown. Also, this removes the various selling costs from the income statement because they are now being netted to determine the net transaction price and revenue.• The amount invoiced will not equal the amount of revenue recognized. To record the transaction a contract liability will be established on the balance sheet for the future credits to be provided to the customer as they take their advertising credits, early pay discounts, etc.
- The Transaction Price Determined Above Needs to be Applied on the Satisfaction of Performance Obligations
The performance obligation will usually be satisfied when the goods are shipped, assuming the terms are FOB shipping point.
- Recognize the Revenue
As mentioned in step three, recording the revenue will create a difference between the amount invoiced to the customer and the amount of revenue to be recognized.
As you can imagine, this is a very simplistic explanation and example of a very complicated change in how revenue will be recognized for GAAP purposes moving forward. It is important that everyone work closely with each other to properly implement this and understand the effect of all the changes discussed. Time is passing quickly, so we recommend that each company create a timeline on how they will work through this process before December 31 arrives.
For more information, contact Mark Thomson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing & Distribution Group.