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Converged Revenue Recognition Standards Usher in Global Guidance for Key Financial Metric

May 29, 2014

After more than a decade of work, the FASB and IASB have published accounting standards by which companies worldwide will calculate and report the top lines in their income statements. The standards eliminate the industry-specific guidance in U.S. GAAP, strengthen the principles in IFRS, and produce a single, principles-based way for companies to report revenue in their financial statements.

The FASB and IASB on May 28, 2014, completed more than a decade of work with the publication of landmark guidance that will change how companies worldwide calculate and report their revenues.

Considered a fundamental measure of a company’s financial health, the accounting boards hailed the global revenue guidance as a major milestone in the FASB and IASB’s up-and-down, years-long attempt to converge key parts of U.S. GAAP and IFRS.

“We worked tirelessly to ensure the standard is as useful and operational as possible, and the result is a standard, I believe, that exceeds in its goal of improving financial reporting,” FASB Chairman Russell Golden told reporters.

The FASB published Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, and the IASB published IFRS 15, Revenue from Contracts with Customers. Companies must comply with the standards in January 2017, but businesses reporting under IFRS may start using the new guidance right away.

The FASB standard erases about 180 pieces of individual, industry-specific revenue guidance in U.S. GAAP and comes up with a single, principles-based process by which all businesses must calculate the top line in their income statements. The standard is being added to the Codification of U.S. GAAP as Topic 606 and will replace the guidance in Topic 605.

The IASB’s standard supersedes IAS 18, Revenue, and IAS 11, Construction Contracts, which critics said don’t help companies calculate revenue for complex transactions.

“It’s hard to overstate the importance of this new standard,” McGladrey LLP partner Brian Marshall said.

Key changes

Under the new standards, companies must follow five steps to come up with their final revenue figure. They must identify the contract, separate each promise contained in the contract, determine the transaction price, allocate the transaction price to the different pieces of the contract, and recognize revenue when or as the business completes the contract.

In a change from current practice, companies must assess the extent by which payments could vary, such as via bonuses, discounts, rebates, and refunds. They also must determine their expectation of collecting payments owed to them by recording revenue only to the extent it’s “probable” they won’t have to make a significant reversal in the future. In addition, they must assess the time value of money in determining the transaction price.

The result is a process that offers fewer bright lines and calls for more judgment compared to current U.S. GAAP.

“It’s going to take a big shift between auditors, management, audit committees, the board room—everyone is going to have to talk well and document well the steps they took to getting to whatever judgments they make,” said Lorraine Malonza, director of accounting policy and financial research for Financial Executives International.

The process may also result in companies reporting revenue earlier than under current practice.

“It will be a mindset change primarily because we used to write revenue guidance in a way that, quite frankly, often said we’re going to do whatever we need to do to make sure revenue doesn’t get recognized too soon,” said Scott Taub, managing director at Financial Reporting Advisors LLC and a former SEC deputy chief accountant. “The new standard tries to balance that. We’re moving the bar a little bit. Maybe we’re not quite right in the middle as far as balancing recognizing revenue too fast and too slow—we’re still worried about recognizing revenue too fast. But we are definitely moving it away from ‘Just Say No,’ which it used to be.”

Companies in industries that relied on detailed guidance in U.S. GAAP, such as telecommunications, real estate, software, and asset management, will feel the most significant changes. A software company selling a video game disc packaged with a one-year plan to play the game online would separate each part of the package as different deals. The company would have to estimate the separate cost for the video game, recognize that amount up front, and then estimate the cost of the one-year online service and recognize that amount during the year.

In contrast, under current practice, the whole package was considered one sale, and the retailer or software publisher recorded the revenue over the one-year online gaming period, the boards wrote in an example to illustrate the standard.

Companies that deal with relatively simple customer transactions, such as clothing retailers, aren’t expected to feel a large shift.

For longer contracts with more variables, the changes to financial reporting practices are expected to be substantial.

Most companies will experience some sort of change, FASB member Marc Siegel said.

“Even if the outcome doesn’t change, the way you think about the process changes or should change,” Siegel said. “You might end up at the same place but have to think about the overall objective.”

In addition, all companies must compile new footnote disclosures about how they came up with their revenue numbers.

The disclosures are supposed to help readers of financial statements understand the nature, amount, timing, and uncertainty of revenue and cash flows from company contracts. Information will be required about revenue breakdowns, contract balances and performance obligations, impairments, significant judgments required to determine the transaction price, and the costs to fulfill or obtain a contract.

Small differences in largely matching documents

The FASB and IASB’s revenue recognition standards are almost identical, save for three main differences.

First, the IASB is allowing companies that follow IFRS the option to adopt the standard earlier than 2017. The FASB is allowing no early adoption for U.S. GAAP.

Second, the FASB’s standard calls for companies to make the same disclosures in annual as well as quarterly financial statements. The IASB scaled back the requirements for interim reports.

Third, the boards both want companies to pass a test, or threshold, to determine the odds of collecting money from customers before recording final revenue figures. Under what the boards call a “collectibility threshold,” companies must assess whether it is “probable” that they will receive their promised payments. IFRS and U.S. GAAP have slightly different definitions of “probable,” however. In U.S. GAAP, the threshold is higher, and “probable” means “likely to occur.” In IFRS, “probable” means “more likely than not.”

Preparing for transition

The FASB and IASB want companies to have as much lead time as possible between the publication of the standards and the deadline they become effective. The size of the documents, however, and last-minute concerns delayed the publication several times. What was supposed to be an early 2013 publication turned to a mid-2014 release, giving companies about two-and-a-half years to gear up for the new accounting regime.

Some companies have said this is not enough time, but IASB Vice Chairman Ian Mackintosh told reporters that the 2017 deadline was firm, barring any “major” issues that crop up between now and then.

Issues will be tackled by an advisory group made up of international companies, auditors, and analysts that the FASB and IASB will assign the task of fielding questions about the standard and suggesting potential changes and clarifications to the accounting boards. The boards will have the final say on whether to follow the suggestions, Golden and Mackintosh told reporters.

The group is being formed as part of a larger effort by the boards to encourage consistent accounting practices.

“One of the challenges we have is if we have separate interpretations… we’re no longer converged,” Mackintosh said. “So we’ll work very hard to keep this converged and keep the global situation in one direction.”

One dissent

All sixteen members of the IASB endorsed the final standard. Five of seven members of the FASB voted in favor of it.

FASB Vice Chairman James Kroeker abstained. He said previously that because he was the newest member of the FASB and not present during most of the debate about the standard, he couldn’t vote on publishing it.

FASB member Harold Schroeder, in a written dissent that was included in ASU No. 2014-09, said he agreed with the standard’s core principle for revenue recognition, but viewed some of its key requirements as being inconsistent with the principle.

Schroeder said it’s wrong to limit the revenue that’s recognized if the sale amount may be adjusted by a bonus or refund.

“Mr. Schroeder believes that those changes made during redeliberations could result in recognition of a biased revenue amount that does not faithfully represent an entity’s actual performance,” his dissent read.

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