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Wednesday, December 14, 2016

Planning for 2017: Leases and Revenue Recognition


The Financial Accounting Standards Board (FASB) has given technology firms plenty to ponder with its new standards for revenue recognition (Topic 606) and leases (Topic 842). As finance leaders head into 2017, they need to start analyzing the broad impact these rules may have on their businesses. It also makes sense to consider both rules together, even though their compliance deadlines are a year apart.

Here’s a quick recap of the new standards and what you need to consider.

Revenue recognition is subjective, for now
The new revenue recognition standard, which was published in May 2014, is very principles-based. So far, we’ve seen a striking amount of difference in the way it is interpreted, among companies and individuals. In theory, as long as you have a defendable basis for your conclusion, you have a lot of leeway in how you handle it. 

That said, the rules are becoming more prescriptive, in response to industry input and the financial market’s push to make company financial statements easier to compare. In 2015 the FASB rolled the implementation date back a year (to January 2018 for public companies and January 2019 for private companies) so it could address industry questions. There have been three updates since then:

  • ASU 2016-08, Revenue From Contracts With Customers: Principal vs. Agent Considerations provides guidance for the gaming and gift card industries.
  • ASU 2016-10, Revenue From Contracts With Customers: Identifying Performance Obligations and Licensing addresses the concept of materiality, a topic that generated a lot of questions from tech companies.
  • ASU 2016-12, Revenue From Contracts With Customers: Narrow Scope Improvements and Practical Expedients discusses collectability, presentation of sales tax, non-cash considerations, contract modifications and completed contracts.

The guidance will likely continue to become more prescriptive. The FASB is still working with industry groups, and we expect to see additional updates as we near the January 2018 implementation date. In order to understand the standard’s impact on your organization, you need to know the aspects that are particular to your industry. As the old saying goes, the devil is in the details.

One interesting detail for tech companies is that―unlike past guidance―there are instances where the new rule will require you to accelerate revenue recognition, rather than defer it.  For example, the new standard eliminates the concept of vendor-specific objective evidence (VSOE), so you may be able to accelerate the recognition of revenue that was historically deferred.

It’s not just about finance and accounting
The repercussions of the new revenue recognition standard extend well beyond the finance and accounting department. You need to consider the rule’s impact on a range of other areas, including:

  • System readiness – How does your ERP service provider plan to handle any additional bifurcation with respect to performance obligations and contracts, for example?
  • Legal – What changes will you have to make to the language in your sales contracts with customers?
  • Commissions – How will they be determined and when will they be earned?
  • Forecasts – How will you reforecast budgets upon implementation of the new standard? How will you educate your board and investors about the differences between your historical revenue forecasts and those under the new revenue recognition model?
  • Financial covenants – How will adjustments in revenue recognition impact compliance with financial covenants? How and when will you discuss the impact with lenders?
  • Taxes – What impact will the new revenue recognition standard have on tax provision, deferred taxes, etc.?  

New lease standard leverages rev rec
In early 2016, the FASB issued another significant rule change: the new lease standard.  This new guidance requires businesses to recognize most leases, including operating leases, on their balance sheets, which they do not have to do under the current rules. This change will have a significant impact on the reported assets and liabilities of many companies, across all industries. The standard will also mean significant additional disclosure requirements, for public and private companies alike.

The timing of this rule was no accident. The FASB meant for the lease standard to leverage the revenue recognition guidance, and the two are tied to one another. As a result, it makes sense to consider the impact of both rules now, even though the lease standard implementation (January 2019 for public companies and January 2020 for private firms) lags the revenue recognition deadline by a year. Analyzing them together could allow you to perform and analyze one reforecast for both, versus two separate reforecasts a year apart, for example.

Other areas to consider
Like revenue recognition, the lease standard will have far-reaching effects. Given its potential impact on a company’s balance sheet, it may have significant ramifications for many financial covenants for example, which is an area companies should address with their lenders sooner rather than later.. 

It’s also going to be interesting to see how lease contracts are redefined. For example, instead of a 20-year lease, we may see companies shortening the lease contract, thereby avoiding large gross-ups on the balance sheet. However, if you end up with a shorter lease which contains an option for extension, you then have to determine the probability you will exercise that option, and for how long. This could result in similar accounting to the 20-year example initially discussed.

The new standard’s definition of a lease will also impact lease agreements. It introduces the concept of “control” and states that to have a lease, you must have control over an asset and its economic benefits. Prospectively, lease agreements will need to define just what control entails for a particular asset.

Similar to revenue recognition, as you analyze the lease standard’s impact on your balance sheet, you also need to consider how to best present the changes to your board and the financial markets. For example, should you separately identify operating leases in your financial statements, or should you lump them in with another line item?

Start talking to your service providers 
Many tech companies will feel a significant impact from both new standards. Even though the implementation dates appear distant, you shouldn’t underestimate the complexity or scope of the potential changes.

The bottom line: You need to start talking to your accountant, your bank, your attorney and your other professional service providers now, so you can understand just how your organization will be affected.

Contact us to learn more about how we can help.

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• Article : Revenue Recognition Standard: Ready, Set, Implement
• Article : Are You Prepared for the New Revenue Recognition Rules?

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