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By Lisa M. Starczewski
On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued a new revenue standard that significantly changes the way in which companies will determine when and to what extent revenue is recognized. The issuance of the new revenue recognition standard is a significant development in financial accounting. However, the application of this new guidance has implications that go far beyond the preparation of financial statements.
All U.S. public companies must file their financial statements in accordance with U.S. generally accepted accounting principles (GAAP). In addition, many private companies choose to apply U.S. GAAP. The FASB promulgates authoritative U.S. GAAP, which is found in the Accounting Standards Codification (ASC). The IASB promulgates International Financial Reporting Standards (IFRS).
For financial accounting purposes, “revenue” refers to inflows or other enhancements of an entity's assets or settlement of its liabilities (or a combination of both) derived from delivering or producing goods, rendering services or any other activity that constitutes an entity's ongoing major or central operations. “Revenue recognition” is the recording of revenue on a company's financial statements. Revenue recognition is a fundamental component of U.S. GAAP. Moreover, the revenue number is often used as an indicator of company value and affects key financial measurements and ratios.
Almost every company applying U.S. GAAP or IFRS will be affected in some way by the new revenue standard because every company will have to apply a new approach to revenue recognition and will be subject to expanded disclosure requirements. At one end of the spectrum are companies that will not see any impact on their revenue numbers, but will still have to understand and implement the new approach. At the other end of the spectrum are companies that will see significant change in established revenue recognition patterns. The new rules will impact certain industries more significantly than others, particularly those that currently rely on industry-specific guidance, which will be superseded by the new standard once it is effective.
The revenue number is relevant in many different types of agreements (in addition to contracts for the transfer of goods or services). For example, revenue is relevant in loan documentation and other financial agreements, management contracts (executive compensation), award-based compensation agreements, buy-sell provisions, etc. Application of the new revenue standard will impact these agreements because how and when revenue will be recognized under the standard is dependent on the terms of contracts, which attorneys often negotiate and draft. Ultimately, consultation with an accountant is necessary to obtain an authoritative opinion as to revenue recognition. However, in many cases, attorneys will need to understand the company's revenue recognition goals and negotiate the contract/agreement with those goals (and the new guidance) in mind.
The fact that the new standard is contract-based offers opportunities for attorneys and accountants to collaborate. Arguably, the better understanding that attorneys have with respect to the big picture (including their clients' financial accounting objectives), the more effective they can be as advocates for those clients.
The new standard provides more than 130 pages of original guidance. This section provides a simplified, high-level overview that attorneys can use as a starting point to understanding the new approach.
Historically, U.S. GAAP has contained specialized revenue recognition guidance for many industries (most notably real estate, software, financial services, entertainment & media, franchises, and engineering and construction). The new guidance supersedes this industry-specific guidance. Accordingly, all contracts to transfer goods or services to customers and most contracts to transfer nonfinancial assets (e.g., real estate) will be subject to one set of general foundational principles regarding revenue recognition.
The core principle is that a company should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled for those goods or services. To apply this principle, a company must consider the terms of the contract and all related facts and circumstances, and apply its judgment.
A company recognizes revenue in accordance with the core principle above by applying the following five steps:
Although the steps appear simple and straightforward, each is dependent on new concepts and determinations. Moreover, each step requires significant judgment and a thorough analysis of the contract terms and conditions with the customer. In other words, the final standard requires companies to approach revenue recognition with a new mindset.
This is true even if the ultimate effect of the new standard on a company's financial statements will not be substantial.
The FASB and IASB have given companies time to analyze and prepare before the new standard becomes effective. For public entities applying U.S. GAAP, the new rules are generally effective for annual reporting periods beginning after Dec. 15, 2016, including interim reporting periods therein. Early application is prohibited. The IASB requires a public entity to apply the new revenue standard for reporting periods beginning on or after Jan. 1, 2017 and is allowing early application.
For nonpublic entities, under U.S. GAAP, the new rules are generally effective for reporting periods beginning after Dec. 15, 2017 and interim and annual reporting periods thereafter, although these entities may elect to apply the requirements a year earlier.
Even though there is a relatively significant time period between the issuance and effective date of this new guidance, the time to begin preparing for its implementation is now. The implications of the new standard are far-reaching and most companies have a great deal of work to do before the effective date.
The elimination of industry-specific revenue guidance in favor of broad principles necessitates greater reliance on professional judgment, customary business practices, and contract terms and conditions. Because the new guidance emphasizes contract terms and conditions, attorneys and other advisers may play a key role in drafting contracts to clearly define when and how a reporting entity transfers control of goods or services.
Because the new guidance emphasizes contract terms and conditions, attorneys and other advisers may play a key role in drafting contracts to clearly define when and how a reporting entity transfers control of goods or services.
Companies need to be analyzing existing contracts to determine the impact of the new principles on their current revenue recognition policies and practices. As an example, companies will need to evaluate the promises in each contract and determine whether application of the new guidance leads to different conclusions with respect to the identification or satisfaction of performance obligations or the computation and allocation of transaction price.
Moreover, companies will have to analyze existing contract language to determine whether contracts need to be combined under the new standard. They will have to analyze warranty language to evaluate how the warranty is accounted for under the new rules. These types of analyses should be done in conjunction with a legal team.
In addition, companies will be drafting new contracts with the changes in mind. Contract terms have always been important; however, they take on an even greater significance under the new approach. There are many instances in the new standard in which contract language is the key to the revenue recognition analysis. Companies need to understand the effect of contractual terms on revenue recognition and consider that effect as contracts are negotiated. There are new “terms of art” in the revenue standard that companies will want to include in their contract language.
In the very first step of the revenue recognition analysis, a company is identifying whether it has a “contract” to which the standard applies.
Attorneys can and will help accountants identify and characterize contractual relationships.
This determination is, in many respects, a legal determination. The standard lists criteria that must be met for an agreement to be considered a “contract.” However, the standard also makes it clear that “enforceability of the rights and obligations in a contract is a matter of law.” Attorneys can and will help accountants identify and characterize contractual relationships.
In addition, when drafting agreements lawyers might consider whether they want the agreements to be within the scope of the revenue standard. For instance, collaborative arrangements are not within the scope of the new revenue standard as long as the counterparty is truly a “collaborator” and not a “customer.”
Thus, if a company does not want the new standard to apply to a collaborative arrangement, the company has to be sure that the contract clearly provides that the parties are sharing risk.
The second step of the revenue recognition analysis is to identify the separate performance obligations in a contract. A performance obligation is a promise to transfer a distinct good or service or a series of distinct goods or services over time that are substantially the same. Attorneys can help accountants identify performance obligations within existing contracts and can draft new contracts using the correct terminology and clearly defining “distinct” goods or services.
A company will recognize revenue under the new standard when a performance obligation that involves a single transfer is satisfied. Similarly, for performance obligations that are satisfied over time by the transfer of substantially the same goods or services, a company will recognize revenue as it satisfies the performance obligation. A company's determination of whether it is satisfying a performance obligation over time—and, therefore, recognizing revenue over time—is dependent upon application of three prescribed criteria.
Much of the analysis of these criteria is dependent on contract terms and conditions. For example, the transfer of a promised good or service is considered satisfied over time if a company's performance does not create an asset with an alternative use to the company and the company has a right to payment for performance completed to date.
Attorneys can help accountants identify performance obligations within existing contracts and can draft new contracts using the correct terminology and clearly defining “distinct” goods or services.
Compensation for performance completed to date includes payment that approximates the selling price of the goods and services, which includes a reasonable profit. The payment terms in the contract are critical to a determination of whether this criterion is met.
Thus, when drafting the contract, a company may want to include or not include certain payment terms with this criterion in mind. In addition, one of the factors in analyzing whether a company has an alternative use for an asset is whether there is a contractual restriction on the company's ability to readily direct the asset to another use. Again, the language in the contract is significant.
The key to revenue recognition under the new standard is the transfer of “control,” not the transfer of risks and rewards. The buzz words are changing, which may affect contract language. The transfer of substantial risks and rewards is one of several indicators that control has transferred, but is not the determining factor. Companies may want to specifically refer to these indicators in their agreements.
Under step three in the new revenue analysis, a company must determine the transaction price. There are special rules on determining transaction price when the consideration to be received is variable (i.e., contingent). Examples of variable consideration involve rebates, refunds, incentives and penalties. Historically, a company could not recognize revenue for variable consideration until the underlying contingency had been resolved.
In contrast, the new revenue standard permits a company to recognize estimated variable consideration before the contingency is resolved, subject to a “constraint” rule. Under the constraint rule, a company may recognize revenue if it is probable that a subsequent change in estimated variable consideration would not result in a significant reversal in the amount of cumulative revenue recognized. The different treatment afforded variable consideration in the new standard (the fact that some variable consideration may be recognized prior to resolution of the contingency) may motivate companies to include or not include certain types of consideration in an agreement. The application of the constraint requires significant professional judgment. A company's accountants may want to discuss these decisions with a legal team.
Under the new guidance, how a warranty is treated depends on whether the customer has the option to purchase the warranty separately and whether the warranty provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. In many cases, companies will need to analyze warranty language, from a legal perspective, to determine which category the warranty belongs to.
In many instances, the industry-specific impact of the new revenue standard may lead to changes in the way in which transactions are structured and agreements are written. For example, in the software industry, the change in the way the transaction price is allocated under the new standard will likely lead to an acceleration of revenue. Under current U.S. GAAP, a software company generally deferred revenue from an arrangement if the company did not have vendor-specific objective evidence (VSOE) of fair value for each deliverable. Under the new standard, revenue will be allocated to each performance obligation even if the company does not have VSOE of fair value.
How will this affect contract terms/negotiation? Companies have more flexibility to include upgrades/enhancements and various types of post-customer support without concern that their inclusion will lead to revenue deferral. Companies will have greater flexibility in developing roadmaps that implicitly or explicitly promise delivery of upgrades to customers.
If application of the new revenue standard results in a change in revenue recognition, that change may necessitate a change in accounting method for tax purposes.
For example, under certain circumstances, advance payments (payments that are due or paid but not yet earned) may be deferred for tax purposes. A proper deferral method for tax purposes requires “book/tax conformity” in the year of receipt, such that a taxpayer may only defer for tax what is deferred in accordance with its financial accounting policy in the year of receipt. Thus, deferral for tax purposes cannot exceed the deferral period for financial accounting purposes. In circumstances in which the new revenue standard accelerates the recognition of advance payments for financial accounting purposes, it may affect recognition for tax purposes as well. If the company changes its book method for the deferred advance payments and wants to use this method for purposes of determining the extent to which advance payments are included in gross income for tax purposes, it is required to obtain Internal Revenue Service consent (by filing Form 3115, Application for Change in Accounting Method).
Even if new book methods do not require changes in tax methods, the new book methods may create additional book/tax differences that will affect the amount of deferred tax assets and liabilities, and could affect the valuation allowance for deferred tax assets. For example, if variable consideration is recognized as revenue for financial accounting purposes earlier than it is for tax purposes, book-tax differences may arise and will need to be tracked.
Changes in revenue recognition may affect transfer pricing strategies and documentation to the extent that a company is using a revenue-based or profits-based method to determine pricing.
The new revenue standard makes changes with respect to capitalized costs. For example, with limited exceptions, companies are required to capitalize the incremental costs of obtaining a contract (under current U.S. GAAP, companies generally may elect to capitalize or expense these costs). Changes in the financial accounting treatment of these costs may have tax impacts (e.g., basis differences).
Both inside and outside counsel should gain a general understanding of the new revenue standard. Attorneys who understand both the current and the new revenue guidance can leverage that knowledge in the following ways:
Because the new revenue standard is contract-based and because the revenue number is significant in so many different business contexts, the new standard offers opportunities for attorneys to provide additional guidance to accountants.
The new revenue standard requires financial statement preparers (mostly accountants) to exercise considerable judgment in analyzing contracts and allocating consideration to various performance obligations within contracts. These preparers may need legal assistance in analyzing existing contracts. Moreover, a company's lawyers may want to draft future contracts in a manner that makes application of the new revenue principles easier. Not only will careful drafting assist financial statement preparers, it also will increase the likelihood that the company's independent auditors will accept the preparer's application of the new revenue standard.
A company's lawyers may want to draft future contracts in a manner that makes application of the new revenue principles easier.
In some cases, although the analysis will be different, the result will be the same—but, in other cases, the new approach will change established revenue recognition patterns. In all cases, the new rules present challenges and opportunities for both accounting professionals and attorneys.
Both inside and outside counsel should be monitoring the impact of any changes in revenue recognition to determine the affect for business and tax purposes. Inside counsel will want to discuss the impact of these rules with the accounting team and reach out to outside counsel to help assess impact and prepare for implementation.
Although these are new financial accounting rules, they present significant opportunities for attorneys to help companies navigate these changes and properly respond to them.
(Lisa M. Starczewski is senior tax counsel for Buchanan Ingersoll & Rooney PC, Philadelphia. She serves as a special consultant to Bloomberg BNA.)
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