As you may know, as the result of a joint project with the International Accounting Standards Board (IASB), the Financial Accounting Standard Board (FASB) issued Accounting Standards Updates (“ASU” or “Update”) 2016-02, Topic 842, Leases, and ASU 2014-09, Topic 606, Revenue from Contracts with Customers. These are some of the most significant and far reaching GAAP changes in many years and probably for a very long while. Shannon & Associates wants to formally call your attention to these standards that will become effective in the coming couple years, but require the start of planning this year.
ASC Topic 842: Leases
This new leasing guidance significantly changes lessee accounting for leases and impacts financial statement presentation as well as financial metrics, including many that relate directly to debt covenants and key performance indicators. The guidance was updated to better align with global accounting for leases and to incorporate the new revenue recognition standard (more on this later).
The new lease standard essentially requires lessees to reflect virtually all leases on their balance sheet. The FASB uses a dual model approach that includes financing leases, which are similar to today’s capital leases, and operating leases, with expense recognized on a straight-line basis. Under the FASB’s dual approach, determining whether a lease is a finance or operating lease will be based on guidance similar to current US GAAP with a more principles based approach. Current GAAP also focused on whether the lease transferred substantially all of the risks and rewards of ownership. The new guidance introduces a right-of-use model, which focuses on a control based approach.
For non-public entities the new standard is effective for annual periods beginning after December 15, 2019 and early adoption is permitted. In the year of implementation, leases for periods greater than 12 months which would’ve been classified as operating leases will be presented as assets and liabilities on the balance sheet and comparative financial statements will need to show the change in both years presented.
ASC Topic 606: Revenue from Contracts with Customers
This new far reaching guidance creates a single model for revenue recognition, with a set of principles to be used in analyzing all contracts with customers that will effectively change how companies across almost every industry will recognize revenue. Nearly everything that businesses and their accountants have traditionally considered a contractual arrangement to deliver goods or services is covered. There are no industries that are scoped out of the guidance, and there is no special guidance for particular industries as there has been in the past, particularly under U.S. GAAP.
The basic principle of this standard is that an entity will recognize revenue when it transfers goods or services to a customer. The amount recognized reflects the consideration “to which the entity (i.e. the seller) expects to be entitled”. To apply the principles in the new standard, an entity will follow a five-step process: 1) Identify the contract(s) with the customer, 2) Identify the performance obligations in the contract, 3) Determine the transaction price, 4) Allocate the transaction price to the performance obligations in the contract, and 5) Recognize revenue when (or as) the entity satisfies a performance obligation.
This process appears simple at first, but the wording of each step has been carefully chosen by the FASB and there are voluminous rules under each of these, evidenced by the full 706 pages of the initial standard.
This new standard also has extensive disclosure requirements related to revenue recognized, and disaggregation of revenue into categories, performance obligations, information on contract balances and activity, information on contracts more than one year, assets recognized for costs of obtaining or costs to fulfill a contract with a customer, information used in determining transaction price, and significant judgments and changes in judgments made in applying the new standard. These current disclosures are expected to expand most Company’s financial statement disclosures about Revenue Recognition from a few paragraphs to several pages.
For non-public entities, the new standard is effective for annual reporting periods beginning after December 15, 2018. There are two transition methods that an entity can use to implement the standards: Full Retrospective with Optional Practical Expedients and the Modified Retrospective. Both will require some form of looking back to prior years presented for either disclosure or changes in revenue recognized, which will mean calculations about revenue for existing contracts and possible past contracts in Companies’ comparative 2019 and 2018 financial statements.
Now is the time to prepare for these fundamental changes. For leases, we recommend management begin to understand the accounting requirements of the new standard, understand the leases the company holds and contemplate the implications for new agreements, assess the capabilities of existing technology for capturing lease data, and develop a plan to implement the new standard. For revenue recognition, we recommend management begin to understand the accounting requirements of the new standard, understand the types of revenue and contracts the company generates and contemplate the implications for new customer agreements, assess the capabilities of existing technology for capturing detailed contract and revenue data, and develop a plan to implement the new standard.
In addition, management needs to communicate with their bank about how the company’s financials may be affected.
Though the financial statements are management’s responsibility, Shannon & Associates is here to help. As requested, we will work with you on establishing your plan, and offering GAAP assistance, training and other resources.