Time to Rethink Revenue Recognition & Leases

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The next couple of years will require preparers and users of financial statements to relearn what they thought they knew about revenue recognition and leases. Two accounting standards will be effective that will create changes to financial reporting: Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, and ASU 2016-02, Leases. The effect of these two standards will cross industry lines, affecting all companies that issue financial statements in accordance with accounting principles generally accepted in the United States of America (GAAP). These changes could have significant effects on those who use and prepare financial statements such as owners, investors, lenders and management, as implementation of the new standards could change the look of the balance sheet, income statement and disclosures going forward. In the year of implementation, every company that issues GAAP financial statements will have to adopt the ASUs. Each ASU contains more than 300 pages of technical guidance. A very brief overview of each standard is provided below.

Revenue from Contracts with Customers

The new revenue recognition guidance replaces substantially all existing guidance for recognizing revenue, including more than 200 pieces of industry-specific guidance. The idea of the new standard is to develop a common revenue standard for all industries and provide financial statement users with more useful information through enhanced disclosures. The ASU is effective for public entities for calendar-year (CY) 2018 and all others for CY 2019.

The fundamental principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration the company expects to be entitled in exchange for those goods or services. This principle must be achieved by following these steps:

  1. Identify the contract(s) with a customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue when (or as) the entity satisfies the performance obligation

What does this mean?

For preparers of financial statements:

  • Apply the five-step model to determine when revenue should be recognized
  • Assess the ASU’s effect and determine what processes should be updated
  • Determine financial statement disclosure requirements

For users of financial statements:

  • Discuss with management the plan for implementation
  • Assess the ASU’s effect on prior- and current-year financial statements
  • Consider the effects on financial metrics, earnings, projections and budgets for potential revenue recognition changes

Leases

The old lease standard had two types of leases—operating and capital—and only required lessees to recognize assets and liabilities for capital leases. Under this ASU, there would be two types of leases as well (financing and operating), but it would require a lessee to recognize a right-of-use asset and a lease liability for both types of leases. The main difference between the new lease types is that finance leases require the income statement effect to be separated between interest expense on the lease liability and amortization expense of the right-of-use asset, whereas operating leases will have a single entry to the income statement as lease expense. The ASU is effective for public entities for CY 2019 and all others for CY 2020.

What does this mean?

For preparers of financial statements:

  • Determine lease classification: financing or operating
  • Record right-of-use asset and lease liability for both lease types
  • Determine financial statement disclosure requirements

For users of financial statements:

  • Discuss with management the plan for implementation
  • Assess the ASU’s effect on prior- and current-year financial statements
  • Consider the effects on financial metrics and debt covenants

If these two ASUs aren’t on your radar, the time to prepare for implementation is quickly passing. Each standard will affect financial reporting in its own way. Review sales contracts, lease agreements and lending arrangements (debt covenants) to make sure revisions aren’t necessary so there are no unintended consequences when the standards become effective.

For a more detailed explanation of the standards, contact David or your trusted BKD advisor.


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