Accounting for Promises Under the New Revenue Recognition Standard
By Ryan Siebel, Partner, Assurance Services
Private companies will be adopting the new revenue recognition standard for periods beginning after Dec. 15, 2018. This means that for companies with a calendar year end, the upcoming year should be spent preparing for the transition. It is important for companies to realize early in the transition process that all of the knowledge needed to make the transition will not necessarily be housed within the accounting function. To truly adopt the new revenue recognition standard, a company must have a complete understanding of the nature of the promises it makes to its customers.
In GAAP speak, these promises are called “performance obligations,” and the new revenue recognition standard requires companies to allocate the cash collected from customers amongst the various performance obligations in a contract. In some instances, this will be a straightforward exercise. If the contract simply requires the company to provide its customer with, for example, the delivery of 500 widgets, then all the corresponding revenue will go toward the single performance obligation—delivery of 500 widgets.
Where the transition could get more complicated is if there are other promises made to customers as part of a contract—and the complications multiply when there is a lack of communication between the accounting function and the sales function, who should have the most comprehensive knowledge of the types of promises made to customers.
Promises to customers to provide maintenance services, extended warranties, or options to purchase additional goods or services at a reduced price may be considered separate performance obligations with separate criteria for revenue recognition.
For example, a company enters into a contract to sell 5,000 units of Product A to a customer and includes in that contract a five percent discount on future purchases of 5,000 units of Product B as an additional incentive to sign. The company would have to evaluate whether the five percent discount represented a separate performance obligation under the contract, which depends on whether it provided a material right to the customer. If so, then the company would not be able to recognize all the revenue on the contract when the units of Product A were shipped. The portion of the revenue representing the option would not be recognized until the option was exercised or expired.
Application of the new revenue standard depends on the accounting function having a comprehensive understanding of all the promises made to customers, which is often easier said than done. This is especially the case when promises are not thoroughly documented, made without prior approval or vague in their nature. Without open lines of communication between accounting and sales, companies risk not appropriately recording what their customers are really paying for.
If you have any questions about preparing for the transition to the new revenue recognition standard, contact Ryan Siebel, Partner, Assurance Services.