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 3, determine the transaction price, is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. To determine the transaction price, an entity should consider the effects of:
- Variable consideration – If the amount of consideration in a contract is variable, you must determine the amount to include in the transaction price by estimating either the expected value or the most likely amount, depending on which method the entity expects to better predict the amount of consideration to which the entity will be entitled.
- Constraining estimates of variable consideration – An entity should include in the transaction price some, or all, of an estimate of variable consideration only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated is subsequently resolved.
- The existence of a significant financing component – An entity should adjust the promised amount of consideration for the effects of the time value of money if the timing of the payments agreed upon by the parties to the contract provides the customer or the entity with a significant benefit of financing for the transfer of goods or services to the customer. In assessing whether a financing component exists and is significant to a contract, an entity should consider various factors. However, an entity need not assess whether a contract has a significant financing component if the entity expects at contract inception that the period between payment by the customer and the transfer of the promised goods or services to the customer will be one year or less.
- Noncash consideration – If a customer promises consideration in a form other than cash, an entity should measure the noncash consideration at fair market value. If an entity cannot reasonably estimate the fair market value of the noncash consideration, it should measure the consideration indirectly by reference to the standalone selling price of the goods or services promised in exchange for the consideration. If the noncash consideration is variable, an entity should consider the guidance on constraining estimates of variable consideration.
- Consideration payable to the customer – If an entity pays, or expects to pay, consideration to a customer in the form of cash or items, such as a credit, a coupon, or a voucher, that the customer can apply against amounts owed to the entity, the entity should account for the payment as a reduction of the transaction price or as a payment for a distinct good or service, or both. If the consideration payable to a customer is a variable amount and accounted for as a reduction in the transaction price, an entity should consider the guidance on constraining estimates of variable consideration.
Howell said one of the keys is to determine if there is some period “where you create some sort of discount in the future to determine the transaction price?” from there you move to the next question, “Is the transaction price fixed and determinable or is there some variable component?” He went to explain that if there are volume purchase discounts that you will provide in the future “and they’re related to the activity you’re undertaking today, what is the potential impact on the revenue over that period of time?”
For a contract that has Foreign Corrupt Practices Act (FCPA) implications and scrutiny, this new element speaks directly to a wide variety of corruption risk. Typically, only attorneys are concerned with such arcane topics as ‘consideration’. However now a judgment call must be made regarding the consideration that can be expected to be achieved and indeed sustained. This would seem to provide a clear area for possible manipulation unless there are sufficient controls in place. While this might not seem like a compliance control, such detect and prevent controls could alert relevant employees, both in finance and compliance, if excessive evaluation or variance was assigned to a large contract with a state-owned enterprise or foreign government.
Finally, this is where the documentation required under a best practices compliance program is so critical. Not only is it evidence to present to a regulator of compliance but it also will form an internal database that a company (or its auditors) can measure against for reasonableness of such variations going forward. 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 fourth element for the new rev rec standard.
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© Thomas R. Fox, 2017