Understanding the Changes to Revenue Recognition Requirements

Back in April 2014, the Financial Accounting Standards Board (FASB) made changes to its Revenue Recognition model in an effort to remove inconsistencies between industries as it relates to revenue requirements. This specific update applies to organizations that enter into contracts, either written or implied, with customers for the transfer of goods and services in exchange for payment.

While public companies have already been adhering to these new standards, non-public entities are now required to adopt them for reporting periods beginning on or after December 15, 2018 (calendar year 2019), and interim and annual reporting periods beginning after December 15, 2019 (calendar year 2020). Although the standard is not required until the calendar 2019 reporting period, it will still need to be applied retroactively to prior periods presented in the financial statements. Therefore, if an organization issues comparative financial statements, the revenue recognition standards should be applied to calendar 2018 as well.

These changes are designed to provide a well-defined, single principle-based standard that can be applied across various industries rather than using the industry-specific standards that currently exist. The new standard also requires additional revenue disclosures. This makes it easier to evaluate a company’s books and ensure there is consistency across transactions.

The core principle of this new guidance is that an organization should recognize revenue when the organization has met each obligation (whether goods or services) under the contract, and the revenue should be recognized at a value that is appropriate for the obligation. In other words, if Walmart pays a snack food manufacturer upfront, the manufacturer cannot claim that as revenue until the contracted obligation (like a shipment or delivery of finished goods) is fulfilled.

NOTE: The new revenue recognition standards do not apply to the following types of contracts: lease contracts; insurance contracts; financial instruments; and guarantees.

What are the requirements?

There are five basic requirements for the Revenue Recognition Update (Topic 606):

Step 1: Identify the contract with the customer

A contract is an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied by an organization’s standard business practices.

Step 2: Identify performance obligations

A performance obligation is a promise in a contract to transfer to the customer either a good or service that is distinct or a series of goods or services that are substantially the same and have the same pattern of transfer to the customer. Examples of performance obligations include: constructing, manufacturing, or developing an asset on behalf of the customer, granting licenses, and granting options to purchase additional goods or services.

Best Practices in DEACOM:

• Set up clearly defined part numbers and descriptions for goods and services.
• Set up Customer Part Cross References to reference the customer’s part number.
• Establish clearly defined Freight Types that establish when the buyer takes ownership of the goods.
• Have a non-stock Freight part, and add it to the Sales Order if Freight Types permit.
• Set up non-stock part numbers for fees.

Step 3: Determine the transaction price

The transaction price is the amount of payment an organization expects to receive in exchange for transferring goods or services, excluding amounts collected for third parties (e.g. sales tax).

Best Practices in DEACOM:

• Use the Sales pricing hierarchy to determine how the price will be populated on orders.
• Establish quotes in the system to send to customers with pricing.
• Use pricing orders to establish customer-specific pricing for items for a certain contract period.

Step 4: Allocate the transaction price to the performance obligation

The revenue recognition standard states that if a contract has more than one performance obligation, an organization should allocate the transaction price to each separate performance obligation in an amount that depicts the amount of consideration to which the organization expects to be entitled in exchange for satisfying each separate performance obligation. The concept is similar to a shopping receipt that is itemized for each product that is bought, the quantities, and the price, rather than just simply stating the final total.

Best Practices in DEACOM:

• Use well-defined part numbers for goods, services, and fees
• Have one line on the sales order per good or service
• Unit Price specified on Sales Order Line should be for the specific good/service

Step 5: Recognize Revenue As the Performance Obligations are Satisfied

Revenue should be recognized as performance when a performance obligation is satisfied by transferring of the good or service.

Best Practices in DEACOM:

• Set up Prepayment part and Prepayment Liability if accepting prepayments.
• Use Settings on Invoicing form to default Invoice Date to Ship Date. Revenue is not recognized until invoicing which happens after shipping.
• Use System Option to recognize revenue on inter-company transfers and cross facility transfers. This works if using multiple companies within a single DEACOM database.
• Use Sales Order Invoice to specify clearly defined part numbers, quantities, and prices.
• Use Freight Terms to set up Retain Ownership In Transit on Freight Types if maintaining ownership until delivery to the customer.
• Set up Terms correctly by specifying when payment will be received.
• Use multi-payment terms and scheduled payments if collecting payments at incremental times then establish dates for when payment is expected.

If companies do not become compliant with these new Revenue Recognition guidelines, they will undoubtedly run into challenges with future audits by falsely representing their revenue per period. It is also important to ensure that the company and vendor in a contractual agreement are aware of the terms so that the proper goods are delivered at the correct price and time.

DEACOM ERP software can save a lot of time for auditors by doing dual postings and ensuring that a company cannot invoice (recognize revenue) until after the goods are shipped or received by the customer (depending on freight terms). This level of process control done through automatic invoicing takes a lot of the manual work and potential for errors out of the equation.