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There have been sweeping changes made to the guidance for revenue accounting within ASC Topic 606 by the Financial Accounting Standards Board (FASB). All December year end non-public companies must be compliant under the new revenue guidance by January 1, 2019. The following article is a very high level overview of the changes, please contact your professional at UHY for our Manufacturing Revenue Recognition Guidance Publication.

INTRODUCTION
From May 2014 through February 2017, FASB has continuously made sweeping changes to guidance for revenue accounting within ASC Topic 606, as part of a FASB convergence project with IASB. Topic 606 is effective for public year end beginning after December 15, 2017 and non-public year ends beginning after December 15, 2018. All December year end non-public companies need to comply with new revenue guidance beginning January 1, 2019.

COMPARISON (OLD VS. NEW)
Under the existing guidance of ASC Topic 605, disclosures on revenue are limited and application of criteria is based on industry specific guidance. Under the new upcoming guidance of Topic 606, disclosures are extensive and uniform, and application of criteria is based on the contract using a five step process to determine revenue recognition. Topic 606 will supersede all existing revenue guidance except a few select industries.

NEW GUIDANCE

FIVE STEP PROCESS
Step 1: Identify the contract
To determine if an agreement is a “contract” under Topic 606, one must answer the following questions:

  • Is the contract approved by both parties?
  • Are the rights of both parties included?
  • Are there payment terms?
  • Does the agreement have commercial substance?
  • Is it probable you will collect for the work performed?

If the answer to any of these questions is “No”, then there may not be a contract in the terms of Topic 606. There are 
special considerations which may delay revenue recognition if a contract is not in place, even if the work has been performed to earn revenue.

Step 2: Identify performance obligations
For a service or good to earn revenue it must be a performance obligation. A performance obligation has utility or value to the customer on its own or with available resources. A performance obligation also is separable from other promises from in the contract. The distinction on whether an item has value and is separable will require a significant amount of judgement. If it is determined a good or service is not separable or has value on its own, it would be linked or bundled with other goods or services until one performance obligation is identified.

An example of this would be building a large machine. If there were multiple parts being created for this machine such as creating a press, an electrical grid, and shell for the machine, it is likely this would all be combined as one performance obligation since they do not have value on their own and are highly interrelated. Other items that did not have a separate revenue allocation under Topic 605, such as an extended warranty or special discount loyalty programs may become a performance obligation with an allocation of revenue under Topic 606.

Step 3: Determine the transaction price
Revenue for a good or service should reflect the consideration which is expected. If there are items which may reduce collections like discounts, rebates, price concessions, time-value of money for items collected over an extended period, and other price reducing factors. The reduction in price would be estimated using a weighted average based on probability of outcomes and revenue would be recorded net of the amount the expected discount or price reduction.

Step 4: Allocation of price to performance obligations
A selling price needs to be allocated to all performance obligations. Assume a manufactured good with an extended service warranty is sold for a single price. For this example there are two performance obligations at a single selling price. Since revenue for the warranty would be recognized over the term of the contract, but revenue on the good would be recognized upon delivery, the selling price needs to be allocated to the separate goods. Common approaches used to allocate selling price to performance obligations are the adjustment market assessment, expected cost plus margin, or residual approach.

If each performance obligation has its own selling price, there will not be any allocation.

Step 5: Recognize revenue over time or at a point in time
Revenue will be recognized over time if the answer to any of the questions below is “yes”:

  • Does the customer receive and consume the benefit provided by the service concurrently? An example of this would be a gym membership.
  • Does the performance create or enhance an asset the customer controls as the asset is created or enhanced? An example is constructing a building on a customer’s property.
  • Does the performance create an asset which cannot be resold to any other party? Does the seller have a right to payment for work performed to date? An example would be building a large machine with a specific use only the buyer could use.

If the standards noted above are not met, recognition at a point in time is used based on these indicators:

  • The seller has a right to payment
  • The customer has legal title to the item
  • The seller has transferred physical possession of the item
  • The customer has the significant risk and rewards of ownership of the asset
  • The customer has accepted the asset

CONTRACT COSTS
Related to topic 606, new related guidance was issued under ASC topic 340-40. There are additional considerations including new contact assets. Under Topic 340-40, costs would be amortized over the expected term of the contract and would be evaluated for impairment periodically. These include cost to obtain a contract and cost to fulfill a contract.

Cost to obtain: This is a cost which is required to win a contract. Under topic 340-40, fulfillment cost is capitalized and amortized over the expected term of the agreement if the cost is:

  • Recoverable
  • Incremental to obtaining the contract (variable)
  • For contract which is expected to continue for more than one year

Costs to fulfill: This is a cost which is required to perform commitments in an agreement. Under topic 340-40, fulfillment cost is capitalized and amortized over the expected term of the agreement if the cost is:

  • Recoverable
  • The cost is directly traceable to the contract
  • The cost enhances assets of the manufacturer
  • Cost does not qualify for capitalization under some other existing guidance. If so, use other guidance.

Disclosures
At a minimum, non-public manufacturers should disclose:

  • Revenue and any impairment losses by revenue source.
  • Disaggregate revenue based on revenue recognized over time vs. a point in time.
  • Opening and closing balances of receivables, contract assets, and contract liabilities.
  • Information about performance obligations such as types of goods/services, significant payment terms, typical timing of satisfying obligations, etc.
  • A description of significant judgements that affect the amount and timing of revenue recognition and changes in those judgements.

TRANSITION APPROACHES
To make the switch to Topic 606, there are two approaches, the full retrospective approach and the modified retrospective approach.

Full retrospective adoption - Entities that elect full retrospective adoption will apply the standard to each period presented in the financial statements. This means entities will apply the standard as if it had been in effect since the beginning of all its contracts with customers presented in the financial statements and will recast revenue and expenses for all prior periods presented in the year of adoption. An entity may use one or more of the following practical expedients with full retrospective adoption.

Modified retrospective adoption - Entities that elect the modified retrospective method will apply the new standard to only the most current period presented in the financial statements. In addition, the entity will have to recognize the cumulative effect of applying the standard as an opening balance at the date of initial application.

CONSIDERATIONS DURING TRANSITION
While preparing to transition, companies should consider creating a transition timeline and plan of action to determine if a full or modified approach will be used. All accounting and finance staff will need to be educated on the standard to provide an understanding of new revenue accounting guidance. Your team will need to review contracts to compute the effects of implementing the new standard including effects of revenue timing on loan covenants.