The Financial Accounting Standards Board recently updated revenue recognition standards, introducing new elements that will require a plethora of additional disclosures for all types of businesses, to varying degrees. The new standards take effect in 2018 for public companies and 2019 for private companies.
The updated guidelines place a greater emphasis on details and judgments aiming to improve comparability, increase consistency across different industries and encourage more transparency. Given the increasing complexities of business around the globe, the new standards aim to use broad-brush techniques to apply principle-driven standards.
The following sectors are among those that will see the most change:
Healthcare: The new standard requires a healthcare entity (such as a hospital group or private practice) to assess the probability of collecting payments for services performed. This requirement could prompt healthcare entities to delay or defer revenue recognition until that assessment is completed. Recognition could be further delayed if there is concern on the patient’s credit risk. These considerations will impact both the timing of revenue recognition and the amount that is recognized. Even for companies that do not see a significant shift in how revenues are being recognized, the new standard will likely require further review of the companies’ current accounting system, processes, and IT infrastructure to determine how the new information required to be disclosed will be obtained.
Real Estate: For developers, the new principles-based approach is largely based on the transfer of control. If the developer’s rights and obligations are legally enforceable, the entity would recognize revenue over time. Alternatively, the developer would be required to recognize revenue at the point in time at which control of the specified unit is transferred. The new principles-based approach is largely based on the transfer of control. As a result, more transactions will likely qualify as sales of real estate, and revenue (i.e., gain on sale) will be recognized sooner than it is under previous accounting standards. The accounting for management fees and other fees that vary based on performance will also change. A property manager will have to estimate, at contract inception, the variable consideration to which it will be entitled and for which it is probable that a significant revenue reversal will not occur. This amount will then be recognized in the period as the performance obligation is satisfied.
Construction: For the construction industry, entities will be required to select an input method (such as cost-to-cost method) or output method (such as units-produced or units-delivered) to measure the progress of each contract and determine the amount of revenue recognized. Under the new standard, if a contractor delivers services to a customer before the customer pays, the contractor should record either a contract asset or a receivable depending on the nature of the contractor’s right to consideration for its performance. This may not coincide with the timing of the invoice as is required under the existing guidance. As a result, companies might have to comb through all contracts to identify and report an expanded amount of details pertaining to the nature, amount, timing and uncertainty of revenue and cash flows.
Manufacturing/Distribution/Retail: The new revenue recognition standard will require companies in the manufacturing, distribution or retail worlds to add more disclosures, but overall the way they currently recognize revenue will not substantially change, assuming that ownership transfers at a certain point in time with no continuing obligations (additional performance obligations) of the seller.
Technology: This industry will be greatly affected by the new revenue recognition standard, particularly software companies. Software is typically sold with various, separately identifiable performance obligations including licenses, upgrades, and perhaps related hardware elements. The individual performance obligations need to be identified and new judgments and accounting policies will be required. In many cases, software companies may recognize revenue on certain of these elements earlier than under previous standards.
Another area to watch will be in the realm of merger and acquisition activities over the next several years as the revenues standards, and new lease accounting requirements that follow a year later may have dramatic effects on some companies’ financial reporting. A key for companies considering a transaction in the next 2-5 years will be to understand how revenue looks today, and what it will look like in the near future. While there are different methods for adopting these new standards with retroactive effects on prior periods, companies may find they need to recast several past years of data for analyses by and discussion with potential suitors. Both the revenue and leasing standards could cause dramatic effects on the evaluation of EBITDA and free cash flow – two measurements often used as a base for the transaction price.
The new standard affects every business regardless of industry, even if the numbers don’t substantially change, there are a number of new disclosures required. As a result, many companies will find the need to update financial reporting systems and train their finance and accounting personnel. Given that transition dates are upon us, those companies that have not started these efforts may find themselves racing the clock to find resources, calculate effects and revise reporting models to meet near-term reporting deadlines.