How to Explain Revenue Recognition Impact to Your Financial Statement Users
The changes to revenue recognition required by ASC Topic 606, Revenue from Contracts with Customers (ASC Topic 606) take a lot of work to implement. For private companies, the fun doesn’t stop once you have drafted your 2019 financial statements. Users of your financial statements, from your auditor to management teams, investors, lenders, vendors, or even high profile customers, might have some ASC Topic 606 questions for you. One question virtually all entities are likely to receive is whether the adoption ASC Topic 606 had a significant impact on the organization upon adoption.
There are varying degrees to which your organization will be affected by changes to existing revenue recognition guidance depending on your types and number of customer contracts, performance obligations identified as well as the extent to which you previously followed industry-specific guidance (e.g., construction, software, etc.).
An initial impact assessment likely gave you a preliminary feel of how ASC Topic 606 would affect your 2019 financial statement, but once you have completed the transition to the standard, you will have a clearer picture of the final outcome. The quantitative impact of the adoption of ASC Topic 606 is reflected by amount of the transition adjustment private companies will record to the opening retained earnings in their 2019 financial statement (depending on the transition method chosen). In addition to the net effect of the adoption impact, certain accounts on the balance sheet could be adjusted, such as receivable, contract assets, contract liabilities, and certain capitalized costs.
The size of your 2019 transition adjustment will come with some unique considerations, particularly for your financial statement audit. The following provides a closer look at what to expect.
Quick Recap: What Is the Revenue Recognition Transition Adjustment?
Entities implementing revenue recognition use either the full-retrospective approach or the modified retrospective approach for their transition to the new standard. The full retrospective approach requires companies to apply ASC Topic 606 to all financial periods presented in their financial statements in the year of adoption, which would result in an organization completing two financial statements under the new standard (2018 and 2019 for private companies), including the required ASC Topic 606 disclosures.
Given that reporting burden, most organizations are opting for the modified retrospective transition approach. The modified retrospective approach requires a cumulative period adjustment on opening retained earnings in the year of adoption – i.e., the 2019 calendar year for private companies.
The cumulative period adjustment is generally going to result in one of the following three “degrees” of impact:
- I have a material adjustment
- I have an immaterial adjustment
- I have no adjustment
I Have a Material Adjustment
Some companies will review all of their contracts and contract terms to find that the timing of their revenue recognition changes significantly from previous practice. Some of the more significant changes stem from the previous use of industry guidance and/or sales transactions that required deferral under the legacy guidance in ASC Topic 605, particularly when bundled transactions could not be separated.
Your adoption of ASC Topic 606 should include documentation and support to explain the application of the underlying ASC Topic 606 principles (5-step process), which should highlight the reasons why revenue recognition was impacted so significantly. The documentation should include a description of the approach used by your organization to evaluate all the contracts in place at the adoption date and how revenue recognition changes applied to those related contract features.
Your company will also need to be transparent about how it computed its cumulative period adjustment and reached its final conclusion that adoption of the new revenue recognition standard resulted in a material adjustment to its opening retained earnings.
Auditors will be likely be interested in your internal control over the sales cycle, including the controls over the adoption of ASC Topic 606. Many auditors may attempt to adopt a control reliance strategy approach over the adoption to reduce the amount of detail testing for the review of the opening adjustment to retained earnings.
Keep in mind that organizations that do not have a significant revenue adjustment when adopting ASC Topic 606 may still have a material adjustment to opening retained earnings. ASC Topic 606 changes the accounting for the cost to obtain and fulfill a contract, so an entity may have significant cost changes to consider in addition to any impacts to revenue recognition.
I Have an Immaterial Adjustment
Many organizations may fall into the “minor impact” camp. However there may still be questions from financial statement users that your entity should be prepared to address. For example, interested parties may want to understand the process used by management to determine the impact on the adoption of ASC Topic 606. Additionally, while you may not have identified a significant adjustment pursuant to the adoption of ASC Topic 606, you should be prepared to discuss why this result was consistent with prior revenue recognition practice.
Similar to the material adjustment scenario, companies with an immaterial adjustment will need documentation to support that all contracts were identified and assessed under ASC Topic 606 in order to reach its conclusion. Support should include the applicable 5-step assessments and underlying computations that indicate the change is a relatively minor one.
Auditors will also be interested in understanding the controls that were applied to assess the adoption of ASC Topic 606, and may test the controls as a way to reduce the extent of any additional testing related to the completeness and accuracy of the analysis performed.
I Have No Adjustment
Many companies are reporting no significant adjustments upon the adoption of ASC Topic 606, but you many find a few financial statement users that remain skeptical of a conclusion that your organization did not have any changes as a result of implementing revenue recognition. You should be prepared to explain the process used by management to adopt ASC Topic 606 and why the adoption did not require an adjustment. If your organization falls in the “no impact” camp, you are not relieved from gathering and retaining detailed support of how you reached your conclusion. You will still need documentation about how contracts were identified and assessed to validate that you did not need to make the historical transition adjustment.
Your auditor will still consider the analysis performed to determine the extent of testing that is necessary over the conclusion that there was no impact to the adoption of ASC Topic 606. For instance, an auditor may conclude that testing of the controls or detail testing is necessary to validate that all contracts and costs that could be impacted by ASC Topic 606 were considered.
While the cumulative effect adjustment from the adoption of ASC Topic 606 may vary across private company entities, the impact on preparing documentation to support your conclusion for your auditor many not vary very much, if at all. Auditors will still need to assess management’s adoption process and application of the ASC Topic 606 principles to determine whether they ultimately agree with the conclusions reached by management.
The impact on disclosure in the 2019 financial statements related to revenue recognition under ASC Topic 606 will be significant for all entities (when compared to past practice). As a principles-based accounting standard, ASC Topic 606 greatly expands the number and type of financial statement disclosures pertaining to revenue recognition.
Additionally, there are some other adoption issues to monitor as well. For example, public companies that adopted ASC Topic 606 early provide insight to some of the financial reporting questions financial statement auditors routinely identified. In order to be adequately prepared to address these risks, your organization should consider reviewing this list to aid in the preparation of your 2019 financial statement audit.
For More Information
If you have specific comments, questions, or concerns about your first financial statement audit under revenue recognition, please contact us.