For most public companies, the adoption of Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, (Topic 606) is finally here. After the long road of preparing for the adoption, companies are finally accounting for transactions under 606, and they are currently planning for 2018 Q1 reporting. This is a great time to look at the challenges that they have encountered. For public companies, this review can offer lessons learned for future reporting. For private companies, who are currently preparing to meet their own deadline, upcoming on January 1, 2019, this review can offer helpful insights for future implementation.
In talking to our clients who are preparing for Q1 reporting, it became clear that three challenges in particular were top of mind:
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- Variable consideration for contracts
Variable consideration includes any consideration that is not fixed, e.g., discounts, credits, rebates, performance bonus, penalties, sales returns, refunds, price concessions, incentives, etc. The variable consideration can be explicitly stated in a contract, or it can be implicit, based on an assumed future occurrence or nonoccurrence of an event.
After the implementation of ASC 606 by public companies, it became clear that there is significant variable consideration with current contracts and that there is very little guidance on how to record it. Under 606, companies are not allowed to recognize revenue that may need to be later reversed, due to unforeseen or foreseen circumstances/outcomes/or something similar. For example, a future rebid introduces variability into the pricing and, related to this, 606 introduces a constraint for the allowed amount to be recognized for revenue.
Companies are currently struggling to quantify these constraints in order to account for them. This fact is especially true for long contracts, where accounting is a challenge because, for each reporting period, these constraints will have to be reassessed. A lot of estimation goes into these amounts, making the accounting difficult to predict.
- Be aware of the constraint.
- As you establish your contracts, test run various options in your planning in order to anticipate several possible future scenarios. This can help you scope expected value.
- Develop processes and controls over the estimations to ensure appropriate financial reporting.
- Contract modifications
Contracts frequently change, as parties may adjust either the price or the scope of the contract, or both. Assuming the change is approved by both parties and enforceable, companies will be required to evaluate the modification through the new framework. Depending on the extent and type of the changes, the amendments to the contract can be recorded as a termination of the old contract and the creation of a new contract, by making a cumulative catch-up adjustment to the existing contract, or a combination of the two.
For example, technology companies contracts often have multiple, multi-year deliverables, with different allocations. As an example, both parties enter into a five-year contract, with numerous deliverables. As the contract progresses, if the customer wants to change the deliverables, the company will need to evaluate the modified contact. This will include determining if the remaining goods or services are distinct and if the pricing on remaining items is reflective of standalone selling prices. Depending on the business, companies will need to plan to evaluate on-going discussions with a customer and determine if a modification occurred.
- Educate contract owners to be aware of what triggers a modification so they can be aware and identify the modifications in a timely manner, and inform finance.
- On the back end, plan for adequate resources to have contracts monitored and to have a plan in place on how to account for modifications.
- Ensure processes and controls are implemented/updated to capture all potential modifications for evaluation.
- Successful communication of 606 adoption to board, investors and analysts
Boards, investors and analysts may not be able to compare revenue reported under 605 with revenue reported under 606 (unless under full retrospective reporting). Companies and CFOs need to be proactive and educate users on the changes to revenue, margins and other key metrics.
For companies under a full retrospective approach, the transition for users will be easier. However, most companies have adopted a modified retrospective approach. As CFOs prepare for earning calls, they need to be ready to explain the impact of adoption and the go-forward impact to users.
Under 606, an entity shall disaggregate revenue recognized from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. Users will need to be educated on the additional information, and companies can expect questions on these expanded disclosures. The disclosure of disaggregation of revenue will also need to provide sufficient information to enable users to understand the relationship with revenue information disclosed for reportable segments under ASC 280, Segment Reporting.
The balance sheet may look different as companies may need to record a “contract asset” and “contract liability.” Again, additional disclosures will be required to provide sufficient information to help users understand these accounts, including related estimates and assumptions. With all this new information, companies need to be proactive, by selectively pointing out and explaining the footnotes that are most relevant to their audience.
- Focus on the details that explain what the new guidance actually means for the core business.
- Pay attention to adjustment to retained earnings: 1) some revenue may never get recognized; 2) some will get recycled.
- Prepare reconciliations to explain and compare revenue under the old GAAP with revenue under the new accounting.
National Audit Leader, Technology Industry
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Steven R. Perkins
US and Global Managing Director, Technology Industry
: +1 703 637 2830