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With Publication of Revenue Standard, Financial Reporting to Change Globally

May 28, 2014

The FASB and IASB’s decade-plus project to rewrite the accounting for revenue recognition is expected to produce a major shift in how companies calculate and record the top lines in their income statements. Considered the “crown jewel” of the standard-setters’ convergence efforts, the standard calls for companies to estimate revenues based on a five-step process that can be applied to all companies, regardless of industry. In some cases, the standard will result in earlier revenue recognition than in current practice.

The FASB and IASB plan to publish on May 28, 2014, a comprehensive standard for companies worldwide to measure and record the top line in their income statements.

Dubbed the “crown jewel” in the accounting standard-setters’ years-long, often fraught convergence process, the revenue recognition standard will eliminate 180 pieces of industry-specific revenue rules in U.S. GAAP and require companies to follow a single set of principles for one of the most important measurements of their financial health.

The FASB said its version of the standard will be titled Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. It will enter the Codification of U.S. GAAP as Topic 606. The revenue recognition guidance is currently found under Topic 605.

The IASB said its version would be titled IFRS 15, Revenue from Contracts with Customers. Companies must comply with the standard in January 2017.

“It’s a very important milestone for the FASB and IASB to come together and issue a joint standard on arguably one of the most important lines on the financial statement—revenue recognition,” FASB member Marc Siegel said. “Irrespective of whatever geography you’re in or whatever industry you’re in, you will have the same kind of paradigm to look through to analyze how and when to recognize revenue.”

The standards call for companies to follow a five-step test to come up with their revenues, which is supposed to be an amount that reflects what they expect to receive from their customers. Companies will identify a contract with a customer, separate the contract’s commitments, determine the transaction price, allocate a price to each promise, and recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.

The change is a major one for U.S. companies, which calculate revenue via standards tailored to specific industries.

“We’re looking at a significant mindset change,” said PricewaterhouseCoopers LLP partner Dusty Stallings. “We are accustomed to having a lot of rules, a lot of bright lines and, again, a very industry-focused direction on what to do. We’re taking away those bright lines, taking away that specific accounting we’re comfortable with, and we’re replacing it with a lot of principles that require estimates and judgment.”

The steps may sound straightforward, but the process gets more complicated for long-duration, multi-element contracts, sales that include incentives for customers with poor credit, or contracts with built-in discounts or performance bonuses. Companies also for the first time must adjust the transaction price to reflect the time value of money.

The breadth of change experienced depends on the industry. Companies that follow specific industry-based U.S. GAAP, such as software, real estate, asset management, and wireless carriers, will feel the biggest changes.

The simpler business-to-consumer sales common to retailing won’t see a significant shift from current practice. Companies that engage in business-to-business transactions are likely to feel a shift. Generally speaking, the longer a contract or the more components it has, the more different the accounting will be.

But nearly all companies will have to compile lengthy, detailed footnote disclosures that break down their revenues by product lines, geographical markets, contract length, services, and physical goods.

“Just because you don’t have a significant impact doesn’t mean there’s not an impact,” Stallings said. “We’re talking about revenue; even if there’s a slight change, you have to get it right.”

Many companies also are expected to record revenues earlier than under current accounting. This is because the new standard will require companies to estimate the effects of sales incentives, discounts, and warranties. For example, under existing U.S. GAAP, if a company has a contract that promises a 10 percent bonus for completing the work by a certain time, the bonus would not be recorded until the company met the deadline and pocketed it. Under the new standard, the company would estimate the odds of collecting the bonus and recognize the revenue at an earlier date.

“That by itself that’s going to accelerate revenues for many companies,” McGladrey LLP partner Brian Marshall said.

Long road to new standard

The standard is more than a decade in the making. Unlike the post-financial crisis calls from investors for the FASB and IASB to rewrite the accounting for banks and other financial businesses, however, there were no such cries from investors and regulators to make ground-breaking changes to revenue recognition.

Instead, the project started when the IASB decided that its revenue recognition guidance in IAS 18, Revenue, and IAS 11, Construction Contracts, needed to be beefed up. In the interest of convergence, the FASB decided to join the IASB’s effort and align U.S. GAAP with IFRS. The FASB also believed it would be better to shift from rules-based, industry-specific accounting to a more principles-based scheme that could be applied to all businesses.

The boards produced their first joint proposal in 2010. After weighing comments and criticism from the public, the boards updated the proposal in November 2011, with the FASB’s Proposed Accounting Standards Update (ASU) No. 2011-230, Revenue from Contracts with Customers, and the IASB’s Exposure Draft (ED) No. 2011-6, Revenue from Contracts with Customers.

The boards initially thought they could complete their work and publish a global standard as early as late 2012. The magnitude of the project stymied them several times, however, as did lingering controversies, such as whether to include a test, or a threshold, by which companies could determine the odds of collecting payments from customers and also resistance from entertainment and pharmaceutical companies that said the proposed accounting for licenses of intellectual property did not capture the realities of the transactions.

Then, the boards got delayed by the sheer size of the document they wanted to produce. A projected publication date of early 2014 turned into mid-2014 as the FASB tried to map the standard to its Codification, and the IASB worked to translate the standard into other languages.

Challenges ahead

Despite the years and the challenges to arrive at the final accounting standard, many accountants, auditors, and companies believe the hard work is yet to come.

The standard is ushering in a sea change to the way companies calculate their revenues, which inevitably means there will be a learning curve.

Despite having more than two years before the standard becomes effective in 2017, most companies must start gearing up for adoption now, especially if they choose to adjust their results from previous periods and follow what the standard-setters call a “retrospective” transition to the new accounting regime.

Regulatory filings will continue to be reported under the existing revenue guidance, but with retrospective application, companies will have to calculate their revenue under the new standard so they can provide the three-year comparison when the new standard becomes effective.

Companies also have the option to make a simpler transition, using what is called a cumulative catch-up method. This would require businesses only to use the new revenue guidance for long-running contracts that exist as of the standard’s effective date. Businesses must disclose in 2017, however, what their revenue figure would have been under the old guidance, so investors can make year-over-year comparisons.

Large companies—especially those most affected by the changes—may have been following the turn-of-the-screw developments in the accounting standard-setting process, but many companies likely have not. Some companies do not believe the 2017 effective date is enough time to implement such a huge change.

“Those companies looking at these issues fresh since the last exposure draft are really going to be hard pressed for time for trying to put resources together, systems in place, and people educated,” said Lorraine Malonza, director of accounting policy and financial research for Financial Executives International. “The time constraints will be one of the biggest challenges.”

For investors and analysts, the new standard may also not guarantee direct, simple revenue comparisons from company to company.

The standard is supposed to usher in a universal accounting language for revenue recognition, but it relies heavily on judgment for companies to come up with their figures. This judgment can differ from company to company, country to country, and CFO to CFO.

“Even though the words may be the same, doesn’t mean they’ll be adopted the same way,” Marshall said.

To ease the transition from current U.S. GAAP and IFRS to the new accounting landscape, the FASB and IASB plan to form an advisory group of companies, auditors, and analysts that will field questions and offer simplification suggestions to the standard-setters before the rules go live.

The boards plan to announce the members of the group in early June.

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