Changes in Revenue Recognition RulesFebruary 03, 2017
Is your business prepared for pending changes to the way you recognize revenue?
Revenue is a critical measure investors and lenders use to assess the well-being of a business. ASC (Accounting Standards Codification) 606 brings pending changes to the way revenue is recognized, in an attempt to narrow the differences between U.S. Generally Accepted Accounting Principles (GAAP), and International Financial Reporting Standards (IFRS). Implementation of these changes begins with 2018 financial reports, but take heed of what will change—sooner rather than later.
What exactly is revenue recognition?
The revenue recognition principle affects all entities (public, private and not-for-profit) and states that, under the accrual basis of accounting, you should only record revenue when an entity has substantially completed a revenue generation process, in other words—you should only record revenue when it has been earned.
What exactly is changing...and why?
Since revenue recognition is a highly regulated process, and companies globally use different accounting standards (generally GAAP or IFRS), this can lead to conflicting reporting results.
The Financial Accounting Standards Board issued ASC 606 to establish a principles-based approach to recognizing revenue, and simplify the discrepancies between GAAP and IFRS.
The new standard uses a multi-step process and will require companies to:
- Better identify performance obligations under contracts (the more unique contracts, the greater effort required to evaluate),
- Demonstrate how the contract price relates to the required activities under the contract and
- Shed light on any assumptions used in recognizing or deferring revenue in various accounting periods.
In addition to this, ASC 606 requires a substantial amount of added disclosure by management, which will allow investors, bankers and analysts reviewing financial information to better evaluate and compare revenue recognition principles utilized by similar companies.
What does this mean for lenders?
Implementing ASC 606 could lead to material changes to revenue reporting by new and current borrowers. Effects on the lender could include:
- Clients with upward adjustments of reported revenue (particularly for growth companies with contract revenue). This means that advance rates or financial covenants may need adjustments by the lender, too.
- Clients with uncertainly as to how ASC 606 will impact them as their existing loans mature and they seek new ones. This will be an issue for small to mid-sized companies lacking the necessary managerial or advisory support to implement the new guidance. Lenders on facilities maturing in the next few years need to prompt their clients to evaluate the impact of this new guidance in time for the lender to gain comfort and draft new documents with appropriate covenants, advance rates, etc.
The new reporting requirements will take effect for 2018 financial statements for public companies and 2019 financial statements for private businesses. Note that companies will also be required to “look back” and restate revenues and/or opening retained earnings consistent with the new principles for prior years as well (beginning with 2016 statements).
Questions? Contact us.