Watch Out for These Rev Rec Pain Points
Private companies: The new revenue recognition standard is coming for you. Before the end of the year, private companies must implement the new 5-step approach to revenue recognition under ASC Topic 606, Revenue from Contracts with Customers. Although there has been plenty of advance notice about the new standard and its implementation deadlines, many private companies have not been proactive with their adoption efforts.
As companies in technology, construction, manufacturing, and other industries move from the initial impact assessment through their adoption procedures, they will want to be on guard for some of the thornier elements in the revenue recognition standard. Being aware of some of the nuances, particularly around certain contract features, will help your company complete its adoption course in time and avoid the costly consequences for a late Topic 606 application.
Companies that offer incentives, including discounts, and loyalty programs to their customers will likely be deferring a portion of their revenues from those contracts until the customer “cashes in” on the discount or loyalty program benefit. From a technical perspective, most incentive arrangements constitute a material right under Topic 606, and the company reports the revenue from that right when the control transfers from the company to the customer, or when the incentive expires. Contract incentives take many forms, including:
- Future Discounts: If customers receive a price list for additional products after they make the first purchase and the items on the price list are discounted from the standalone selling price, the price list constitutes a separate material right. Companies would calculate the amount of revenue to be deferred as a result of that right by factoring in the estimated likelihood of a future purchase and the amount of the discount.
- Volume-Based Pricing: Tiered or volume discounts provide the customer with a material right if they must make an initial purchase at a higher price to earn a discount on any subsequent purchases.
- Free Services: Providing services at no additional charge—such as free consulting services in connection with a product purchase—usually provides the customer with a material right. The selling price for that right is based on the hours expected to be used and the standalone selling price of the “free” service.
- Loyalty Programs: Whether the loyalty program uses points, miles or other rewards, the program likely contains a material right. The selling price for that material right is based on the value of the incentive earned as well as the value of incentives accumulated over time.
Not all warranties will have the same accounting treatment under the new revenue recognition standard. Those that provide a service beyond the base level of assurance associated with traditional product warranties are separate performance obligations, resulting in a deferral of revenue and recognition over the service period. Examples include:
- Manufacturer’s Warranty: The estimated cost of fulfilling a one-year warranty obligation is accrued when control of the product is transferred and would not impact revenue.
- Five-Year Warranty with Annual Maintenance Services: Warranties that provide the customer with annual maintenance services, going beyond product assurance would be considered separate performance obligations.
- Long-Term Warranties: Covering a product “for life” provides a service beyond assurance and is considered a separate performance obligation. The estimate of the product life is used to calculate recognized revenue.
Acceptance & Return Provisions
Customers typically have a chance to accept or return a product for a period of time after they receive it. Future returns are estimated and recorded as a reduction of revenue, along with a corresponding refund liability. There are some provisions that may have different treatment:
- Percentage Payment Terms: When a final percentage of payment is due upon customer acceptance, it is considered a formality that does not impact transfer of control.
- No Right to Return: Even if a contract doesn’t include explicit rights to return a product, the vendor’s business practice may provide an implicit right. If this is the case, returns should be estimated and recorded as a reduction of the transaction price.
Rebates & Price Provisions
The contract price can change depending on rebates, price matching, and price protection provisions. These clauses are forms of variable consideration and should be estimated and recorded as an adjustment to the transaction price. For example, if a company agrees to issue a partial refund if a competitor lowers its price on a similar product or if the company sells the product to a different customer at a lower price, then it would recognize revenue when the control of the product transfers to the customer. It would estimate the potential refund and record it as a reduction in the transaction price.
The new standard will permit over time recognition for customized goods in some instances, which is a change from the point-in-time recognition under previous guidance. Overtime recognition occurs when the asset being created has no alternative use and if the manufacturer has an enforceable right to payment for performance throughout the life of the contract. For example, if the manufacturer receives a payment for performance even if the customer cancels the contract (for reasons other than a breach of contract by the manufacturer).
Fees related to the cost of fulfilling a contract, including nonrefundable set up, access, activation, initiation, joining, or membership fees, are typically not separate performance obligations, or may represent a material right, and are recognized when the control has transferred, or, if applicable, the material right is exercised or expires, even when they are paid for by the customer at the beginning of the contract.
Differences, typically greater than twelve months,between the customer’s payment and the timing of the vendor’s performance indicates the contract contains a significant financing component. This is accounted for separately from the contract revenue and will affect the total amount of revenue recognized. For example,
- Extended Payment Terms: A good indicator you have a significant financing component are customer payment terms longer than one year for a product delivered upfront. Reporting entities would have to determine which part of the revenue from their customer arrangement is attributing to financing and which part is related to the product because the portion attributed to financing is not considered revenue (rather it is interest income).
- Advance Payment for Services: Paying in advance for services performed over two years provides the vendor with funding for upfront costs and may contain a significant financing component.
Multi-year contract may include price increases to reflect changes in inflation or market rates for services. These price increases should be evaluated to determine whether they reflect separate performance obligations, otherwise they would be recognized as part of the transaction price. For example, if the contract language includes a fee schedule with a percentage increase for each year of the contract, but the contract includes only one performance obligation satisfied over time, then the vendor providing the service would have to determine the appropriate measure of recognizing revenue over time. A “right to invoice” practical expedient may apply.
Some contract modifications may affect more than one contract, or result in an existing contract to be terminated and new one issued instead. Accounting for contract modifications will depend on whether the modification adds a new performance obligation or distinct service and that service is being provided at its standalone selling price.
- Contract Amendments: If modifications add distinct goods or services priced at their standalone selling price, the modifications would be considered separate contracts from the original contract.
- Contracts for New Services: If a change to a contract adds a new service at a significantly discounted price, the change is generally viewed as a modification of the existing contract.
For More Information
If you have comments, questions or concerns about how any of these more difficult-to-apply revenue recognition considerations will affect your organization, please contact a member of our revenue recognition team.