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 continue considering 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 rule 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 2: Identify the Performance Obligations in the Contract, requires the following:
A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. If an entity promises in a contract to transfer more than one good or service to the customer, the entity should account for each promised good or service as a performance obligation only if it is (1) distinct or (2) a series of distinct goods or services that are substantially the same and have the same pattern of transfer.
A good or service is distinct if both of the following criteria are met:
- Capable of being distinct—The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.
- Distinct within the context of the contract—The promise to transfer the good or service is separately identifiable from other promises in the contract.
A good or service that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct.
Howell said, “The second step is to determine what are the performance obligations. Again, those performance obligations may not be immediately obvious to the casual observer and the contract needs to be picked apart to determine if those performance obligations are such that you would recognize that or complete that at a point in time, or if you’re going to be performing those over a period of time. If it’s for a period of time, what period of time?”
Obviously with any type of revenue recognition standard, “there are judgments made about the performance obligations themselves, if they’re performed at a point, if there’s some period of time, what is that period of time? Those all need to be documented and you need to have a process to monitor the future contracts that are going to be entered into by the company or any modifications to the contract or to the performance obligations.”
These time points are critical as obligations that are performed can be satisfied revenue recognized over time or at a point in time. One commentator has stated, “Performance obligations are satisfied over time if one of the following criteria is met: (1) The customer simultaneously receives and consumes the benefit as the entity performs; (2) The performance creates or enhances an asset that the customer controls; (3) The asset created has no alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.” Somewhat surprisingly and not consistent with prior rev rec rules, the possibility of the contract with the customer being terminated should not be considered relevant.
For a contract that has Foreign Corrupt Practices Act (FCPA) implications and scrutiny, this new element may well cause consternation. Typically when a party performs, payment is due. However under this element there can be partial performance, a rolling performance or something altogether different. Some third party representatives may have contracts that read more like customer agreements contemplated under Topic 606, for example commissioned sales agents and distributors are two which come to mind. If there is now more flexibility on payment, will it allow nefarious actors to manipulate both data and financials to hide the creation of pots of money to pay bribes? Chief Compliance Officers (CCOs) and compliance practitioners need to consider these issues in the context of compliance internal controls going forward.
Tomorrow I will consider the new third element for the new rev rec standard.
What does partial performance mean for contract payments to 3rd parties under the FCPA under the new rev rec standard?Click to tweet
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© Thomas R. Fox, 2017