United States: The Ripple Effect Of New Revenue Rules: Are You Prepared?

Recently, the world's governing bodies reigning over accounting practices issued a new revenue recognition principle that must be adopted by Jan. 1, 2017, for most public companies and Jan. 1, 2018, for most private companies.1 This principle is expected to have wide-ranging impacts on how revenue will be recognized and reported in future financial statements. In brief, the standard setters elected to supersede existing rules-based revenue recognition requirements in favor of a more principles-based method of recognition (i.e., the application of judgment using broad-based principles).

Think beyond financial reporting

What business owners, management and other stakeholders need to know is that this change will affect more than the financial statements. The comparability of historical financial information, fair value measurements, methods for preparing forward-looking information and business risks may be significantly impacted by this change. For this reason, management, directors and key stakeholders must think beyond financial reporting to assess whether the change in revenue recognition principles will affect future decision-making. Consider the following:

Historical financial performance comparisons

The new revenue recognition principles allow, but do not require, retroactive application to prior periods. Therefore, for those enterprises choosing not to apply the changes to previously reported financial information, which may be a likely outcome due to the costs, financial reporting comparability may be compromised for some companies due to the timing of recognition and other issues. In addition, the new principles require management to determine if there is a financing component to each transaction.

If so, interest income and expense may differ from past reporting practices, potentially impacting operating ratios, debt covenants and other performance measures. In most instances, the change in revenue recognition standards, including the interest component, will impact business measurements based on EBITDA. For example, a $100 contract with deferred customer payment could result in a transaction price (revenue) of $90 and interest income of $10. The bottom line ultimately does not change, but EBITDA would be less if a portion of contract consideration is characterized as interest.

What you can do to prepare

Assemble key stakeholders to assess the impacts of the change on your business. Evaluate information requirements for financial reporting and disclosures. Work with external stakeholders to adjust expectations and payment arrangements. Review financing agreements and modify terms to avoid violation of debt covenants.

Fair value measurements

The new revenue recognition rules have the potential to impact a number of valuation estimates, including:

  • Reporting unit valuation for impairment testing purposes — reporting units are often valued using methodologies based on multiples of revenue, EBIT and EBITDA, all of which may be affected by the revised guidance.
  • Enterprise valuation for share-based compensation purposes — again, these entities are often valued based upon market multiples.
  • Contingent consideration arrangements — often, a component of a target company's purchase price is based on the achievement of future revenues, EBITDA or other measurements.
  • Acquired intangible assets such as patents and trademarks — these are often valued and revalued by applying royalty rates to an expected revenue stream.
What you can do to prepare

The magnitude of the impact remains to be seen. In general, the use of estimates will continue. Until the markets get used to the new models behind the numbers used in fair value measurements, there could be more work involved to determine fair values and provide complete disclosures of methods and assumptions.

Policies, procedures and internal controls

Existing policies, procedures and internal controls over financial reporting may need to be changed to comply with the new requirements. This includes consideration for contract assets and liabilities, and other assets likely to be reported under the new standards. Amortization methods and lives, impairment assessments, and financial reporting footnote disclosures are just a few of the matters to be decided by management. Any such changes will require training, monitoring and the implementation of new performance metrics.

What you can do to prepare

Increase your focus on change management. Design and implement appropriate systems, policies, procedures and controls to monitor the transition to the new guidance. Prepare and train management, the board, finance, sales and other internal organizations that will be directly impacted.

Revenue-based arrangements

Most businesses have arrangements based on revenue recognition or earnings derived from revenues. The new revenue recognition standards will impact revenue-based arrangements, such as sales commissions, sales- or earnings-based compensation and bonuses (potentially including stock-based compensation), buy/sell agreements, representations and warranties, earnouts, and litigation damages computations, to name a few. In turn, standard performance measurements will need to change, and there may be an impact to selling, general and administrative costs reported for financial reporting purposes.

What you can do to prepare

Review compensation plans and performance metrics. Adjust targets to reflect any changes in the timing of revenue.

Taxes

For those businesses adopting the new revenue recognition standards, you may need to request a change in accounting method for U.S. tax returns. Also, book to tax reconciliations will be impacted, transfer pricing may need to be re-evaluated, and deferred taxes will require additional attention.

What you can do to prepare

Have your tax professionals work closely with your accountants to assess the impact of the revenue recognition changes on the calculation of tax liabilities and planning strategies.

Fraud

Revenue recognition has historically been an area subject to higher than normal risks for fraud and restatement, and that was under a rules-based standard.2 Many believe that the new revenue recognition standards, based on principles that require significant management judgment, will create more risks for fraudulent reporting. Examples include risks related to sham sales, conditional sales, round-tripping or recording loans as sales, premature revenue recognition, faulty cutoff for sales, improper percentage-of-completion revenue recognition, unauthorized shipments, and consignments wrongly recorded as sales.3 In part, this is due to the significant judgment required to be exercised by management to determine if there is a contract, what the obligations are under the contract, allocations of transaction prices and the completion of obligations.

What you can do to prepare

Evaluate reporting systems and direct monitoring procedures to critical business processes. Seek professional assistance to assess risk, and design a plan for your organization to safeguard assets and maintain financial integrity.

Are you ready for the new revenue recognition requirements?

Considering the extent of impact and potential unintended consequences stemming from the new revenue recognition accounting requirements, business owners, directors and management should begin to prepare for the changes. As a start, you should review existing plans and programs. You may require an outside perspective to upgrade systems and implement new processes and procedures. The new standard will affect more than the top and bottom lines of your financial statements. Don't get caught wondering how it will impact your decision-making.

Footnotes

1. On May 28, 2014, the FASB, the body governing U.S. GAAP, and the IASB, the body governing International Financial Reporting Standards (IFRS), issued authoritative revenue recognition guidance (Accounting Standards Codification 606 for U.S. GAAP and IFRS 15): "The guidance in this Update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets..." The U.S. GAAP version of this standard is effective for public companies for periods beginning after Dec. 15, 2016, and after Dec. 15, 2017, for nonpublic entities.

2. Beasley, Mark S.; Carcello, Joseph V.; Hermanson, Dana R., and Neal, Terry L. Fraudulent Financial Reporting: 1998-2007, An Analysis of U.S. Public Companies, pg. 4. Scholz, Susan. Restatement Trends in the United States: 2003–2012, pg. 7.

3. Beasley, Mark S.; Carcello, Joseph V.; Hermanson, Dana R., and Neal, Terry L. Fraudulent Financial Reporting: 1998-2007, An Analysis of U.S. Public Companies, pg. 18.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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