What Government Contractors Should Know About the New Revenue Recognition Standards
Many organizations still haven’t implemented the Financial Accounting Standards Board’s (FASB) latesst guidance on revenue recognition: Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers. This revenue standard will supersede virtually all revenue recognition requirements in US GAAP (“Generally Accepted Accounting Principles”). The standard outlines a single comprehensive model for revenue arising from contracts with customers, and supersedes ASC 605-353 (formerly SOP 81-1) and most other current revenue recognition guidance (including other industry-specific guidance). As a result, government contractor business entities may have to change many key revenue recognition practices.
The deadline for implementation is Jan. 1, 2018, for calendar year publicly-held companies, and Jan. 1, 2019, for calendar year privately-held companies. Although the implementation date for non-public companies is over one year away, our dedicated Government Contractor practice specialists encourage clients to start evaluating the changes now to understand the impact on their financial statements.
In this article, we will provide an overview of the revenue standard’s main provisions, provide best practices for implementation methods, and identify key issues that may impact government contractors during implementation. This guidance will be especially beneficial to entities following the AICPA’s Industry Revenue Recognition Task Force for Aerospace & Defense.
Main Provisions of the New StandardThe new standard is more principle-based than current revenue recognition guidance and will require government contractors to exercise more judgement. The principle is based on a five-step model from the AICPA Revenue Recognition Guide:
Step 1: Identify the Contract with a Customer
The standard includes characteristics that need to be met for a contract to permit revenue recognition. In general, a contract exists if there is an agreement between a buyer and seller that creates enforceable rights and obligations for the two parties. Only when there is such an agreement is there any revenue to recognize under Topic 606. This step sets the base to which the rest of the steps in the model are applied.
Also included in this step is guidance on when to combine multiple contracts into a single contract for revenue recognition purposes, and what to do if a contract is modified, thereby changing the identified contract with a customer.
Step 2: Identify the Performance Obligations in the Contract
Among the rights and obligations that will be set forth in the contract (either explicitly or implicitly), are:
- 1. The right of the buyer to receive goods or services from the seller, and;
- 2. The obligation of the seller to provide those goods or services to the buyer.
If multiple goods or services are promised, the seller must determine whether each good or service is distinct from other goods or services in the arrangement, or must instead be combined with other goods or services to form a bundle that is distinct from other goods or services in the contract.
Each good or service that is distinct, or each bundle of goods or services that is distinct, is called a performance obligation under the standard. Performance obligations are then used as units that are evaluated for revenue recognition purposes in the rest of the model.
Step 3: Determine the Transaction Price
In addition to rights and obligations over goods or services to be provided, a contract will include:
- 1. The obligation of the buyer to pay the seller for the goods or services, and;
- 2. The right of the seller to collect that payment from the buyer.
However, the vendor needs to determine whether all amounts to be collected are appropriately reported as revenue. In addition, the contract may include terms that make the transaction price variable. For example, the transaction price could vary due to usage-based payments, award and incentive fees, rights of return or refund, or economic price adjustment.
Topic 606 explains when, and how much, variable consideration is to be included as part of the transaction price. This will generally require variable consideration to be included in the transaction price to the extent it is probable such consideration will become due under the contract.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
In this step, the transaction price determined in Step 3 is allocated, or assigned, to the performance obligations identified in Step 2. Obviously, if there is only one performance obligation, this allocation is easy, as the entire transaction price is allocated to the single performance obligation. However, if there are multiple performance obligations, the transaction price must be allocated to those performance obligations.
Generally, this is done based on the stand-alone selling prices of the performance obligations in the contract. The stand-alone selling price of a performance obligation may be objectively determinable if the performance obligation is regularly sold on a stand-alone basis. If it is not, its stand-alone selling price must be estimated through a reasonable technique.
Once stand-alone selling prices for all performance obligations are estimated, the transaction price is generally allocated based on the relative values of the performance obligations, effectively allocating any discount in the contract to the performance obligations on a pro rata basis.
Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation
Once the transaction price has been allocated to the performance obligations in the contract, the amount of revenue allocated to each performance obligation is recognized when, or as, the entity performs the obligation as required by transferring the promised goods or services that make up the performance obligation to the customer.
A good or service is deemed to be transferred to the customer when the customer gains control over the good or service. A customer sometimes gains control of promised goods or services as performance occurs over time. In other instances, the customer gains control of a promised good or service at a single point in time, often when something is physically delivered to the customer.
When a performance obligation is satisfied over time, the seller must determine an appropriate measure of its progress toward satisfying the performance obligation, and then recognize revenue based on that progress measurement applied to the amount of the transaction price allocated to the performance obligation.
When a performance obligation is satisfied at a point in time, the seller must determine the appropriate point in time at which to recognize as revenue the amount of the transaction price allocated to the performance obligation.
Implementation MethodsFull retrospective application: Recast of prior period financial statements (with an adjustment to opening retained earnings for the first year presented). For example, for a public company, 2016 and 2017 would be recast to reflect the adoption of the new standard presented in the 2018 financial statements. The cumulative adjustment would be reflected as of Jan. 1, 2016.
Modified retrospective application: Cumulative effect of initially applying the standard is recorded as an adjustment to opening retained earnings of the period of initial application. Under the same example, 2016 and 2017 would not be recast in the 2018 financial statements. The cumulative adjustment would be reflective as of Jan. 1, 2018.
Implementation Issues and GuidanceFor government contracts, the type of contract will determine if there will be a change from current revenue recognition practices. For time and materials and cost-plus-fixed-fee contracts, as well as services-based firm-fixed-price contracts, there will be minimal change to the total revenue and timing of revenue recognized under the new revenue standard. Under more complex contracts (i.e., award fees under cost-plus contracts, or firm-fixed-price contracts where the entity performs manufacturing, design, development, integration, and/or production), applying the new standard will require careful analysis and consideration, and could impact the timing of revenue recognition.
The AICPA’s Industry Revenue Recognition Task Force for Aerospace & Defense has identified various revenue recognition implementation issues and continually updates the list of issues as discussions continue.
The following are some of the key areas to consider when implementing the new guidance as noted in the AICPA’s Industry Revenue Recognition Task Force for Aerospace & Defense.
Acceptable Measure of Progress – what to consider when measuring progress towards completion of performance obligations satisfied over time.
Accounting for Contract Costs – considerations for applying the guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 340 for incremental costs of obtaining a contract, costs to fulfill a contract and amortization and impairment, to costs typically incurred in aerospace and defense contracts, including pre-contract costs and learning or start-up costs.
Variable Consideration – considerations for estimating the amount of variable consideration (incentive fees, award fees, economic price adjustments) in aerospace and defense contracts, the impact of subsequent modifications, and how to determine the amount of estimated variable consideration to include in the transaction price.
Significant Financing Component – considerations needed to assess whether a significant financing component exists in determining the transaction price for various types of aerospace and defense contracts.
Allocating the Transaction Price – considerations for determining how to allocate the transaction price to multiple performance obligations in aerospace and defense contracts.
Implementation Plan for Government ContractorsThe AICPA Financial Report Center developed an implementation plan that may be helpful as a starting point for developing your own implementation plan. Below are the high-level steps included in that plan.
- Designate the individual(s) responsible for overseeing implementation.
- Evaluate how the changes will impact how your company accounts for different types of revenue streams/contracts. Consider how the new standard will impact current performance metrics and compensation plans. Work with your auditor to discuss the completeness and accuracy of your analysis.
- Determine an implementation method (full or modified retrospective approach).
- Determine changes that may be needed within systems and/or software applications to facilitate revenue recognition under the new standard.
- Determine what interim disclosures may be required prior to the effective date.
- Develop a plan for implementation to incorporate the above steps, as well as train your staff.
- Educate the company’s management on the new standards and the impact you expect the changes to have on the company’s financial statements.
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