In May 2014, a new, and more importantly a single revenue accounting model was finalized and will replace the old guidance. Yes it is here! It took around 10 years for the Financial Accounting Standards board (FASB) and International Accounting Standards Board (IASB) to release these standards and I believe it is the single most across-the-board important topic that they could have tackled in the last decade.
So what does this new standard do? Did we need it? How is it different? What are the underlying principles? Does this demand new business strategy?
Well, these are great questions and will be tackled by us in the next few blogs in detail. But right now it is important for us to focus on the overall difference between the old and new guidance and take some time to thoroughly understand the variation.
The new standard essentially has been released to, “establish the principles to report useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue from contracts with customers.” What does it entail in practice? It intends to – remove inconsistencies and weaknesses in existing revenue requirements, provide a more robust framework for addressing revenue issues, improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets, provide more useful information to users of financial statements through improved disclosure requirements and simplify the preparation of financial statements by reducing the number of requirements to which an organisation must refer. The American Institute of Certified Public Accountants (AICPA) blog notes that the new standard “eliminates transaction and industry-specific guidance and replaces it with a principle based approach that applies to all public, private and not for profit entities.”
The Wall street Journal’s blog notes that public companies have until 2017 to prepare for it, and adds that software makers and wireless providers, among others, could record revenue more quickly than before, while for example, auto and appliance makers may see the opposite trend.
A very interesting article in CFO Magazine points out that new standard was “strongly opposed by many finance and accounting executives”.
New changes could have a ripple effect on loan covenants, compensation packages, discounts, rebates, taxes, and even new company start-ups.
The literature is all over the place and sometimes it might get hard to know where to look when confronted with new situations in revenue recognition. It is a contract based approach and the core principle is to “recognize revenue in a manner that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitles in exchange for those goods or services.”
The timing of revenue recognition will be similar to current practice for some transactions but you won’t know for sure till you apply the new guidance to a specific company’s specific circumstances. One key difference that PwC points out is that revenue from contingent fees (including performance bonuses or royalties) might be recorded earlier as compared to today’s model. Other differences include new approaches for reporting fees from licensing intellectual property and capitalizing contract-related costs. Additionally, the time-value of money could affect the amount of revenue recorded for longer term contracts.
All functions of a business have to be ready before implementing the new guidance. It has to be a cross functional effort to adopt the principles seamlessly. Like any change, there will be effects that will be noticed over a longer period of time and effects that will also come as a surprise. Changes to the top line always have a broader impact on other parts of the business.
This means some existing agreements may have to be renegotiated, adjusted and recreated to maintain their original intent.
The 5 principles although very simple, are going to be more complex in application and hence the FASB and IASB have set up a joint transition resource group that will meet publicly until the standard goes fully into effect. The in the meanwhile, preparers worldwide need to start working on getting ready for the implementation.
Stay tuned to our future posts and also follow us on our social media channels, where we will be dwelling into more detail about each of the five steps of the new standard.