This week I am exploring the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), for public business entities, certain not-for-profit entities, and certain employee benefit plans, which was issued in May 2014. The amendments become effective for public entities for annual reporting periods beginning after December 15, 2017. In other words, we are now less than six months away from a new Revenue Recognition (“new rev rec”) standard which may significantly impact the compliance profession, compliance programs and compliance practitioners going forward. I recently sat down with Joe Howell, Executive Vice President (EVP) at Workiva Inc. and asked him if he could walk me through some of the key changes and how it might impact compliance going forward. Today we begin to consider the first of the five elements of the new rev rec standard.
The key to understanding the new rev rec standard is that it is judgment based, not rules based. This will allow more room for interpretation but also allows for more room for manipulation. This is where the new rev rec standard intersects with compliance and where the compliance practitioner needs to not only understand the new rev rec standard but also understand the role that internal controls will play in complying with this new standard going forward.
There are five elements that you must consider to make a determination of whether revenue can be recognized. FASB identifies these five elements as the following:
FASB states that Step 1: Identify the Contract with a Customer, as follows:
A contract is an agreement between two or more parties that creates enforceable rights and obligations. An entity should apply the requirements to each contract that meets the following criteria:
- Approval and commitment of the parties;
- Identification of the rights of the parties;
- Identification of the payment terms;
- The contract has commercial substance; and
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Howell said, “The first step is to figure out what the contract is, and the most important point there is that contracts do not need to be written. The key about what is the contract means that if your business practices differ from what’s written in the contract, you have to make a judgment about which survives. For example, if you have a contract that says you have 90-day return privileges but you as a business practice always give 360 or 365 days return, what’s the contract? Is the contract the 90 days that’s written or is the contract the 365 days that you’re actually giving?” Obviously in the compliance world, the failure to follow the contract terms and conditions can raise one very large red flag as it might signify conduct the compliance function has not evaluated or approved.
But Howell points out how the failure to follow one of the most basic compliance requirements, i.e. following the terms of a contract, can negatively impact a company’s ability to recognize revenue under this new standard. “If you don’t have a contract, if you legitimately don’t have a contract, then you can’t recognize revenue until you actually get the cash. This can most often occur when a company follows a business practice that is not recorded or written. One would determine that the company has a business practice that was simply not written down. Of course, there are companies which ship based upon POs alone but in that case you must discuss any pricing concessions that might be given in the PO and from that point try and determine what that actual contract might be going forward. This means your company may have a contract of some kind but it may be enforceable only as a business practice not as a written contract.”
Howell also noted another important consideration is that a written contract represents the performance obligations of both parties. Moreover, there may “be some sort of credit factor that is considered in the contract and that’s something that’s quite new that changes the way the judgments need to be formed. In the past, you would have reserves for bad debt now you need to factor in to the actual revenue the amount of the revenue that could be affected by lack of ability to perform through any revenue that could be recognized until you actually collect it.”
Given that a written contract is specified in the Ten Hallmarks of an Effective Compliance Program as a key internal control, you can easily see how the lack of such a written agreement can fall into the realm of compliance. Even Foreign Corrupt Practices Act (FCPA) enforcement actions are relevant here as one of the well-known bribe-funding tactics is to provide a discount to a customer but not credit the company’s books but instead take the actual discounted amount and give to a corrupt official as a bribe. With this first element of the new rev rec standard apparently recognizing that the lack of a contract is not an impediment to eventually recognizing revenue, compliance practitioners may well need to more thoroughly review contracts with governmental entities or state-owned enterprises.
Tomorrow I will consider the second element for the new rev rec standard, performance obligations.
How does the obligation for a business standard over a written contract for rev rec impact compliance?Click to tweet
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© Thomas R. Fox, 2017