by Cydney Posner
The warnings are everywhere—it’s time to get serious about revenue recognition. The new standard is expected to result in significant changes to measuring, recognizing and reporting of revenue—regarded as the key line item in the financials for most companies. While the impact of the new standard will be certainly be felt on the bottom line for most companies, even when the new rule is not expected to have any material impact on the financials, the related disclosures may well be material, according to Sylvia E. Alicea, Professional Accounting Fellow, Office of the Chief Accountant, in remarks at the Bloomberg BNA Conference on Revenue Recognition. Moreover, the SEC is expecting to see robust transition disclosures by the third quarter of this year, and the staff is watching closely.
According to Alicea, the new revenue recognition model “aims to more closely reflect the economics of an entity’s contracts with customers as well as management’s expectations for consideration they expect to be entitled to in exchange for transferring the promised goods and services to its customers. The new model is also comprehensive. It has different concepts and enhanced disclosure requirements. It will require reasonable judgment to apply—and those new concepts, disclosures and judgments may require changes in systems and related controls.”
The disclosures required by the new standard are particularly important. Alicea indicates that they “are designed to allow an investor to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The pertinent facts and related reasonable judgments related to a registrant’s contracts with customers, including the significant judgments made in applying the principles of the new revenue standard, should be disclosed to better inform investors’ decisions.” And, as reported in Bloomberg BNA, other panelists at the conference suggested that assigning concrete numbers to estimates of the impact of revenue reporting in the disclosures “can be a sensitive topic with a company’s managers,” particularly in connection with concerns about competitive harm.
SideBar: For a discussion of the impact of the new revenue recognition standard on the life sciences industry, including R&D arrangements, variable pricing terms (such as milestones) and rights of return, see this PubCo post. And the new standard also has tentacles that reach executive compensation (see this PubCo post).
As discussed in this article in CFO.com by a Deloitte partner, many companies seem to be focused on the more high-profile aspects of the new standard, such as the revenue and measurement requirements, but giving short shrift to the required disclosures:
“many companies are largely ignoring the new disclosure requirements, treating them as a minor detail that can be quickly and easily addressed once the other requirements have been satisfied. That’s a mistake. A common misconception is that revenue disclosures are just like ‘showing your work’ in math class—i.e., simply documenting whatever calculations you made to arrive at your revenue numbers. But the disclosure requirements actually involve much more. Continuing the math class analogy, it’s as if your teacher isn’t just demanding that you show your work, but also that you write an in-depth essay explaining the approach you chose, why you chose it, what assumptions you made, what tools you used, and what processes you followed to ensure nothing would go wrong.”
Typically, annual reports are where comprehensive disclosures debut; however, because of the timing of effectiveness of the new standard, the author notes that “this year’s annual reports will not include the newly required disclosures. Instead, those disclosures will need to be covered fully in next year’s first quarter report,” which could “present some major challenges” with regard to meeting deadlines.
The author then identifies some of the new disclosure issues that he views as most challenging:
- “Performance obligations. Companies are required to disclose the portion of a transaction’s price that is allocated to “remaining performance obligations” (terms of the contract that have yet to be satisfied), and then explain when in the future the company expects to recognize the revenue associated with those unsatisfied obligations. For some companies, this may require estimates that extend years into the future.
- Significant judgments and estimates. Companies are required to disclose information about the methods, inputs, and assumptions they used to both (1) estimate the amount of “variable consideration” (rebates, performance bonuses, refunds, etc.) included in the transaction price, and (2) estimate the likelihood of significant revenue reversals when the uncertainty associated with some or all of the variable consideration is resolved.”
Other disclosure issues may arise in connection with the requirement to explain changes in contract asset and liability balances resulting from events such as business combinations, impairments, contract modifications, variations in progress and other events. Similarly, companies are required to disclose out-of-period revenue adjustments, that is, revenue being recognized in the current reporting period that resulted from the satisfaction of performance obligations in a previous period, for example, as a consequence of changes in estimates. These types of challenges, the author advises, must be evaluated in light of “materiality, relevance, the specific information that will be needed (and how to get it), and which controls will be necessary to prepare and review the disclosures and related underlying data.”
However, even before the new standard becomes effective, companies will need to focus on making transition disclosures. In her remarks, Alicea reported that the staff has recently been focused on transition disclosures about the anticipated effects of adoption of the new standard. Where the effect is not known or cannot reasonably be estimated, the company should disclose that fact, together with “a qualitative description of the effect of the new accounting policies, and a comparison to the company’s current accounting to aid investors’ understanding of the anticipated impact. It should also disclose the status of its implementation process and significant implementation matters yet to be addressed.”
In recent periodic reports, some companies have reported that they do not expect the impact of the new revenue standard to be material; however, says Alicea, “[e]ven if the extent of change on the balance sheet or income statement is not deemed to be material, the related disclosures may be material. The scope of the new standard addresses not only amounts and timing of revenue but also new, comprehensive disclosures about contracts with customers, including the significant reasonable judgments the registrant has made when applying the guidance. Accordingly, the basis of any statement that the impact of the new standard is immaterial should reflect consideration of the full scope of the new standard, which covers recognition, measurement, presentation, and disclosure.”
SideBar: The SEC has been warning about the need for transition disclosures for quite a while. As far back as 2015, then-SEC Chief Accountant James Schnurr advised that companies will need to provide disclosures about the anticipated impact of the new standard on the financial statements, warning that the SEC “expect[s] the level of these disclosures to increase between now and adoption….” [emphasis added] (See this PubCo post.)
Alicea also emphasized the importance of effective internal control over financial reporting for these disclosures: as management makes headway on its implementation plan, effective internal controls are necessary to identify appropriate disclosure content on a timely basis. (In his article, the Deloitte partner also stressed the need for new controls and procedures related to gathering data and identifying, preparing and reviewing applicable disclosures and related information.) In designing controls “and considering their necessary level of precision,” she continued, “management should consider, among others, the nature of the transition disclosures in light of the status of the company’s implementation efforts and the objective of these disclosures.”
Application of the principles of the new revenue standard “may require reasonable judgment, and in some cases, those judgments may necessitate changes to internal control over financial reporting.” In light of the level of judgment required for implementation, attention to controls that mitigate the risk of fraud were viewed as especially important:
“At its core, fraud is the result of decisions or actions by individuals. As such, management should carefully consider how the transition to new GAAP standards will affect opportunities, incentives, pressures, attitudes, and rationalizations in a manner that could drive changes to previously identified fraud risks….For example, during transition to the new revenue standard, companies should consider whether the potential for management bias in reasonable judgments required to apply the new guidance may lead to the identification of new fraud risks. Potential examples related to areas of judgment susceptible to management bias include the identification of performance obligations, the estimation of standalone selling price for distinct goods and services, as well as the estimation of variable consideration when determining the transaction price. It is important for management to consider whether new or changes in internal controls are warranted to reduce the risk associated with management bias. For example, management may want to establish a framework that defines how management will execute the judgments required in the new GAAP standards. This may allow for a more consistent application of the principles in the new GAAP standards that helps reduce the risk of management bias.”
In addition, audit committees will need to oversee the changes made by management to the company’s system of ICFR in transitioning to the new revenue recognition standard. Also, keep in mind that, as indicated in prior Schnurr reminders, each company will need “to consider its quarterly obligations to disclose material changes to ICFR.” [emphasis added]