While the new revenue standard is “old news” for the majority of public companies, spring of 2020 will be the first time most private companies close their 2019 books and report under ASC 606. As they make the final push to adopt the new guidance, we have compiled a few key reminders related to the audit of the ASC 606 implementation, first time reporting under the new standard, and key things to consider post adoption:
Show Your Homework
While it’s not uncommon to hear the perspective that adoption of ASC 606 will have no or immaterial impact on revenue recognition, a common pitfall is to not prepare sufficient documentation to support this claim. A company must, at the very least, provide evidence of the thoughtful process undertaken in order to demonstrate to the stakeholders (board, investors, lenders and auditors) that implementation of ASC 606 truly does not materially impact the financial statements. While this evidence could take different forms, our experience is that it generally falls within the following broad categories:
- Scoping Document - Demonstrates how the company assembled their revenue contracts into homogenous groups, how many contracts were detail-reviewed within each group, and the rationale for the sample selection. The scoping document should also address the “untested” population (the contracts or groups of contracts that were not detail-reviewed and why).
- Detailed Contract Review - Analyzes and documents the contracts selected for review under the five-step framework of ASC 606. Reviewing only what’s written on paper is generally not enough to fully understand the substance of the arrangement and conclude on the appropriate accounting treatment. Therefore, discussions with company personnel who have firsthand knowledge of the contracts (specifically, legal department, pricing / sales and those in operations) are often required as a supplement to the reviews.
- Accounting Policy Memos - Summarizes the application of the five-step framework to each revenue stream and zero-in on the key areas of accounting judgement. This document can also form the basis for the company’s accounting policies and procedures going forward.
It’s All About the OBS … and the Recast
When adoption of the new standard results in material changes to the timing or amount of revenue recognition, there are a few items a company should keep in mind as it works through the opening balance sheet (OBS) adjustments and recasting of the 2019 and, depending on the method of adoption, 2018 balances:
- Has the full population of contracts requiring adjustment been identified?
The contract provisions that cause differences between legacy guidance (ASC 605) and ASC 606 may not currently be tracked, thereby making it difficult for a company to identify the full population of contracts requiring adjustment. For example, ASC 606 requires certain contract options (known as material rights) to be accounted for as separate performance obligations. If these contract options were not accounted for historically, it may be difficult for a company to identify the full population that contain these provisions and therefore require an OBS adjustment. Completeness of the contract adjustment population is a key focus of the auditors.
- Is the change a correction of an error?
It is not uncommon to uncover situations where historical application of ASC 605 has not been exactly on point, and it may not always be clear whether a revenue recognition difference is truly the result of the adoption of the new standard versus the misapplication of legacy revenue guidance. In these cases, judgment is required and timely discussion with the auditors is recommended. This is an opportunity to cleanup historical accounting and to establish the correct policies and practices going forward.
- What about the transactions?
Private companies frequently change ownership or engage in acquisitions themselves. If transactions occurred during the term of the contracts that were in place in 2018 or 2019 (depending on the method of adoption), the application of the new standard may be impacted. Specifically, transactional activity (e.g., acquisition) resets the opening balance sheet of the target company that in turn effectively reboots the start date of a revenue contract. This will impact balance sheet accounts, as well as the remaining amount of revenue that will be recognized in the income statement.
- What about other FSLIs?
When the timing and amount of revenue changes, other financial statement line items (FSLIs) would also be impacted. Namely, deferred (contract liabilities) and unbilled revenues (contracts assets) would likely change, although bookkeeping for accounts receivable and the related bad debt reserves would largely be unaffected. In addition, the new standard requires companies to defer certain costs to obtain and fulfill a revenue contract (e.g. commissions). Finally, as a result of the revenue changes, tax impacts would need to be considered.
Are We There Yet?
While the overall level of impact from adopting the new revenue standard can vary significantly depending on industry and company-specific facts and circumstances, no company is immune to the change altogether. Our experience is that the level of change falls within one of the following three categories:
- Material changes to the timing and amount of revenue would likely require significant changes to the revenue recognition process, including updates to data, systems and controls. Significant process and system changes generally take a substantial amount of time to implement, and unless the company started the process early, an interim (likely a manual) solution would be needed for initial adoption and through 2020 with a more long-term solution being employed for future reporting periods.
- Immaterial changes to the timing and amount of revenue likely do not necessitate significant process changes but will require a periodic evaluation of the relevant conclusion in order to continue to support the assertion that the changes are immaterial. The company will need to determine the frequency of such an evaluation (likely in consultation with their auditors).
- In cases where there is no change to the timing and amount of revenue, companies still need to consider implementing an ongoing process to perform contract reviews following the model prescribed by the new standard. Additionally, the new standard includes a few quantitative and qualitative disclosure requirements that may be complex and can lead to significant process and data capture changes. While a majority of these disclosures are optional for private companies, exit strategies (i.e., IPO or a potential purchase by a public company) should be considered.
Regardless of the ultimate level of change, it is important that a robust and thoughtful approach is applied to implement this new guidance.