Large public companies, most notably Verizon and Workday, have been preparing for what has been considered one of the most historic accounting changes to hit the market in decades (Forbes), NetSuite ASC 606/IFRS 15. Verizon has been preparing for this transition over the last 3 years. Workday has a dedicated team of accountants reviewing all their contracts and making adjustments to their financial statements.
The new standards have affected organizations in different ways. Some companies have reported higher profitability ratios, while other companies have shown decreases. Uber, for example, had reported $3.4 billion in revenue for its first quarter of 2017 but has now restated it to $1.5 billion for the same quarter under the new standards.
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This shift in accounting standards has the potential to impact a company’s structure, from sales strategies to employee compensation plans. Organizations that are the most directly affected are those that have subscription-based business models, and the software industry will be especially affected, as it operates under very specific revenue recognition rules. The transition to the new accounting standards will likely generate complex changes within many organizations.
BUT WHAT IS NetSuite ASC 606/IFRS 15 AND HOW DID IT COME TO BE?
NetSuite ASC 606/IFRS 15 was created after twelve years of development by the Financial Accounting Standards Board and its European counterpart, the International Accounting Standards Board. Their underlying goal was to simplify and synchronize the revenue recognition practices between GAAP and IFRS customers related to contract revenue. The shift streamlines all the different accounting standards from around the world into a global accounting standard. As a result, accounting standards have transitioned from rule-based to principle-based and allow financial users to exercise professional judgment to accommodate the growing changes in the global economy.
The core idea of the new accounting standards for contract revenue is simple: an organization will recognize revenue, which will represent the transfer of a good or service to a customer as outlined in the contract, and an organization will be compensated proportionately to what has been delivered to a customer.
The standard defines the accounting requirements for determining if an agreement is a contract subject to NetSuite ASC 606/IFRS 15 through a five-step assessment approach:
Step One – Identify the contract with a customer
NetSuite ASC 606/IFRS 15 considers a contract to be within the scope of the new standards when all of the following conditions are met:
- The contract is approved by parties involved
- Each party’s rights are identified regarding the goods or services to be transferred
- Payment for goods or services is identified
- The contract has commercial substance
- The collection is probable once goods or services have been provided
If any contracts do not meet all the requirements, then the organization will continue to reassess those contracts going forward to establish if they meet the new standard.
Step Two – Identify the performance obligation in the contract
When a contract is approved, it is the responsibility of the organization to assess the goods, services or performance obligation that has been promised to the customer. A performance obligation is a good and/or service that is distinct, or a series of goods and/or services that have the same pattern of transfer to the customer over a given period of time. A good or service is considered distinct if a customer can benefit from it on its own or in conjunction with other readily available resources, and the organization’s promise to transfer the good or service to the customer is clearly defined.
Step Three – Determine the transaction price
The transaction price is the compensation which the organization expects to receive after the transfer of the good or service. If the contract has variable components, then the organization will need to provide a reasonable estimate of those components.
Step Four – Allocate the transaction price to the performance obligations in the contract
If a contract has multiple performance obligations, the organization will allocate the transaction price to each performance obligation within the contract by assessing the relative standalone price for each obligation. The accounting standards suggest the following approaches to assess the standalone value:
Adjusted market approach – This approach considers the market in which the good or service is sold and estimates a price that a customer in the market would be willing to pay. This approach is applicable where the price of a similar good or service can be used as a basis for the analysis.
Expected cost plus a margin approach – To assess the standalone price under this approach, an organization would forecast the cost of fulfilling the contract obligation and include a margin that the market would be willing to pay on the established cost. The cost plus the margin markup would be the standalone value of the contract obligation.
Residual approach (not a recommended approach) – The residual approach can only be used in limited scenarios and an organization must first attempt to utilize another acceptable method to reach the estimation. Under this approach, if a contract has multiple performance obligations, an organization can allocate the remaining amount of the transaction price to goods or services that do not have an observable selling price.
The key takeaway from Step 4 is that the contract obligation price charged to the customer may not be consistent with revenue earned once the obligation has been delivered.
Step Five – Recognize revenue as the organization satisfies a performance obligation
Once a performance obligation has been fulfilled and control has been passed to the client, the amount of revenue related to the performance obligation that has been fulfilled is recognized. Control of an asset is determined through the direct use of, and by the ability to obtain direct benefits.
With the new accounting standards, organizations will need to evaluate the impact of these changes on their business and work with accounting firms to assess the transition process. The key question now is, how well can NetSuite handle this shift in accounting standards? Read our blog, How Does ASC 606/IFRS 15 Impact NetSuite Customers? to learn more.
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