Are you Ready for Revenue Recognition and Lease Accounting?
Barnes Dennig held its annual Accounting Standards Update Seminar at the Xavier Cintas Center last Fall. The discussion was led by Barnes Dennig Director, nationally recognized speaker, and Technical Director of the AICPA’s Center for Plain English Accounting and founding member of the Private Company Council, Tom Groskopf, CPA, CVA, MBA. The seminar focused exclusively on the upcoming changes to lease accounting and revenue recognition within U.S. GAAP.
The content of the program went beyond a discussion of what is written in the new guidance, and instead focused on the impact to companies, who within those companies will be most impacted, and why. Those that will be impacted the most might have considered the seminar as either a wake-up call, or a sobering reminder about the implications of the guidance, especially as it relates to their internal processes and controls and their current ERP systems. Understanding the potential impact is especially important, considering that calendar-year privately-owned companies, meaning those that do not meet the definition of public business entity, have approximately fifteen-months (as of the date of the seminar) to implement the new revenue guidance, with new lease guidance following twelve months later.
Of these two major accounting changes, the new revenue recognition guidance has the potential to have the most impact on businesses. Groskopf informed us that the most impacted companies will be those with limited internal controls over their contracts with customers. Groskopf emphasized that the accounting under the new revenue recognition guidance must be assessed on a contract by contract basis (or by pools of contracts, if the results are not materially different than accounting contract by contract), and one method cannot be presumed. Controls over contracts are also important considering contracts do not necessarily need to be in writing but must be enforceable in the jurisdiction in which the contract is governed. However, with respect to performance obligations, oral promises to customers and promises implied by past history can be considered separate distinct performance obligations within a contract, and can have revenue recognition implications. Having control over these promises and contracts is essential in order to comply with U.S. GAAP under this new standard. Furthermore, based on the existence of certain terms in the contract, the new revenue recognition rules may require the transaction price of performance obligations be recognized as the performance obligation is satisfied (akin to current accounting known as percentage of completion), versus recognizing all at a single point in time. Finally, certain transactions may not meet the definition of an enforceable contract, which would result in deferral of this revenue (absent legal termination of the contract), until consideration is collected from the customer and all performance obligations are satisfied.
Groskopf also mentioned that many ERP systems will not be able to handle recognizing revenue in accordance with the new standard. This is the case because most systems use the issuance of an invoice as the basis for recognizing revenue which, for various reasons, including some mentioned in the above paragraph, will most likely not be in accordance with the new guidance in many cases. As a result, many companies may be forced into posting adjusting journal entries based on manual calculations using spreadsheets. He noted that the inherent weaknesses in a manually based process will leave entities prone to material weaknesses in internal control.
On leases, since operating lease obligations will now be recorded on the balance sheet (instead of being shown only as a footnote disclosure), Groskopf emphasized, similar to revenue, the importance of identifying and reviewing contracts in order to identify all operating lease obligations and separate lease and non-lease components. A review of agreements is important as certain contracts could meet the definition of a lease which would require balance sheet capitalization. The definition of a lease is the new “on/off switch” for balance sheet recognition, which replaces the current four objective tests to determine a capital lease. The definition of a lease is based on the substance of the contract and not the form. He indicated that some entities will apply today’s operating lease disclosure requirements based on whether the header of the contract is titled “lease.” This may not capture all contracts that meet the definition of a lease under the new lease standard.
Groskopf also mentioned that the new treatment of operating leases could have an adverse impact on the results of certain covenant ratios in loan documents, and encourages companies to consider the impact of the new operating lease guidance in advance, so that covenants can potentially be reset prior to a violation occurring.
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