Revenue Recognition Transition Methods: No Time to Delay

Often companies don’t consider the transition rules for a new accounting standard until very close to the date of adoption.  In the case of the new revenue recognition standard, this may not be the smart approach. The new standard offers two transition methods, “full retrospective” and “modified retrospective.”  Under the full retrospective method, an entity records revenue under the new standard in its income statement for all periods income statements are presented with the cumulative effect of adopting the new standard recorded to retained earnings at the beginning of the earliest year presented.  Under the modified retrospective method, an entity records revenue under the new standard in the period of adoption, records the cumulative effect at the beginning of the period of adoption, and does not restate comparative income statements to comply with the new standard. However under the modified retrospective method, disclosure of what revenues and costs of revenue would have been under the old standard is required in the year of adoption.

One may wonder, “why go through all the trouble and extra work involved with using the full retrospective method?” The full retrospective method may be more complicated and time consuming, but its benefits may outweigh the costs. Companies will need to determine how the new standard applies to them and how that impacts the decision on the transition method. An obvious reason a company might want to apply the full retrospective method is to provide greater comparability and transparency of financial statements for management, shareholders, lenders, analysts, etc., to give them a full understanding of trends. Also, a company may want to get ahead of, or at least be consistent with, what its industry is going to do.

The lack of comparability of revenue and costs before and after adoption of the new standard can have a significant impact on a company’s decision. In the case of the modified retrospective method, revenue may be recycled or vanish when comparing the year of adoption and the year immediately prior.  For example, a company (particularly in the software industry) may have recorded deferred revenue under the old rules at the end of the year immediately prior to the year of adoption. However, under the new standard, that revenue may not have to be deferred.  Therefore, the deferred revenue will never “flush through” revenues in the post-adoption financial statements. It would simply disappear. It would be absorbed by the cumulative effect of adoption recorded to retained earnings.   Similarly, some costs that were recognized up front when under the old standard may be deferred under the new standard.  So the income statement in the year immediately before the adoption and the year of adoption may double up contract costs.

Therefore, early in the adoption process, companies should turn their attention to the transition methods. Companies should consider the possible detrimental effects on comparability and assess what the company’s industry is going to do. Public companies will be required to adopt ASC 606 in annual reporting periods beginning after December 15, 2017 and for interim periods within in the year of adoption. Those entities may early adopt ASC 606 as of fiscal years beginning after December 15, 2016 and for interim periods within the year of adoption.

Private companies are required to adopt ASC 606 in annual reporting periods beginning after December 15, 2018, and for interim periods in the year following the year of adoption. Private entities may early adopt ASC 606 in fiscal years beginning after December 31, 2016, and for interim periods beginning either in the year of adoption or one year after the year of adoption.

If you are a calendar year end public company that reports three years of income statements, implementing the full retrospective method will require that you restate the financial statements for two years prior to the year of adoption. This will necessitate a second set of books to account for revenues and contract costs under the new standard beginning in 2016 (or 2015 if adopted early). For private companies it depends on how many years of comparative financial statements are presented. Consequently, companies simply will need adequate time to get systems ready for recordkeeping under the new standard.

Fortunately the FASB provided three possible practical expedients for companies utilizing the full retrospective transition method, such as:

1. For completed contracts, an entity need not restate contracts that begin and end within the same annual reporting period.
2. For completed contracts that have variable consideration, an entity may use the transaction price at the date the contract was completed rather than estimating variable consideration amounts in the comparative reporting periods.
3. For all reporting periods presented before the date of initial application, an entity need not disclose the amount of the transaction price allocated to the remaining performance obligations and an explanation of when the entity expects to recognize that amount as revenue.

Even though these effective dates seem far down the road, early consideration of the transition method is paramount. If you ultimately decide to use the modified retrospective method and you are sure about it, great.  However, if you decide to adopt the full retrospective method or are unsure, you need to jump on it now. If you decide on the full retrospective method, it will be harder to develop and document prior year revenue data after the fact than to do it real time. In fact, it may not be possible unless it is done real time because of changes that may be necessitated to accounting systems and data that needs to be gathered in real time.  Each method has its pros and cons, so a company should proactively weigh its options to decide what method it will use.

For a complimentary one hour initial consultation on how the new revenue recognition standard will affect your organization and more information as to how Puncel Consulting Associates can assist you, visit www.puncelconsulting.com/revenue-recognition, or contact us at lpuncel@puncelconsulting.com. Check out our blog at https://www.puncelconsulting.com/blog/.