Although it’s been almost a year since the new revenue recognition standard officially went into effect for public companies, many industries are continuing to struggle to understand and implement the complex new rules. In fact, many manufacturers and distributors are finding that adopting the new standard requires changes in everything from their accounting processes and financial statements to operational practices and valuations.
To accurately align your business with the new standard, it’s vital to understand the five-step model that companies will need to use to determine revenue recognition correctly.
The Five-Step Model
The new revenue recognition standard seeks to replace the old rules that vary by industry and replace them with a principles-based approach that can be applied across every industry. To do this, the new standard requires businesses to follow a five-step model for recognizing revenue:
- Identify the contract. A contract will be any arrangement (written or oral) that creates enforceable rights and obligations. The contract must have identifiable payment terms, and the entity must expect to collect the final payment in exchange for that obligation being met.
- Identify the performance obligations in the contract. A performance obligation represents the promise to transfer a distinct good or service to the customer.
- Determine the transaction price. The transaction price is the amount of consideration to which a company expects to be entitled in exchange for transferring goods or services to a customer.
- Allocate the transaction price. The transaction price should represent the amount of consideration the company expects to be entitled and should be allocated for each performance obligation.
- Recognize revenue when the performance obligation is satisfied. After completing the above four steps, revenue may be recognized.
Steps one and two of this model are relatively straight forward. For manufacturers, the contract will include the company’s obligation to produce a specific good and the promise to transfer ownership of that good to the customer by an agreed-upon date.
Step three is where things can get tricky, especially for many manufacturers whose prices may change depending on certain variables. For example, the transaction price may be affected by several variable considerations, including things like rebates, price matching, slotting fees, early completion, credits, term discounts, and returnable goods.
Unlike past rules, manufacturers must now address these factors in each contract, opposed to recognizing the full amount of revenue and then including various discounts as part of the selling expenses. Manufacturers must now estimate these variable considerations and apply them to the original item invoice amount to get a new transaction price that reflects the correct amount of revenue to be recognized.
Because of this, income statements will only show the net revenue number — rather than gross revenue with multiple considerations that reduce the net revenue. The various selling costs will also be removed from the income statement. Additionally, the amount of revenue recognized will be different from the amount invoiced. That’s because a contract liability will be established on the balance sheet to reflect the credits and discounts that are being provided to the customer. This will come into play when it’s time to recognize revenue in step five.
Steps four and five of the five-step model will include delivery of the agreed-upon performance obligation, payment, and recording the revenue for that product or service.
Implementing the New Standard
As mentioned, implementing the new revenue recognition standard can be quite complicated, especially for manufacturers and other industries with intricate production processes. Proactive planning will be key to implementing the new rules, along with ensuring your team understands the effects any new processes will have on their everyday operations.
If you want to learn more about how the new revenue recognition standard will affect your business or want to find out how CRI can help you with the implementation process, please reach out to us.