FASB’s new revenue recognition standard is presenting challenges for financial statement preparers as well as auditors as public companies race toward implementation at the beginning of 2018.
A new AICPA audit and accounting guide for revenue recognition is designed to provide industry-specific guidance to preparers and auditors in their implementation efforts. The guide, prepared by the AICPA Financial Reporting Executive Committee (FinREC), was issued in December but will be updated throughout 2017 and beyond with more guidance from various industry task forces.
The guide also provides general information for preparers and auditors. Here are brief excerpts from some of the guide’s advice for preparers in aerospace and defense and asset management industries, as well as audit practitioners on understanding the entity they are auditing.
Aerospace and defense preparers: This excerpt is relevant to Step 5: “Recognize Revenue When (or as) the Entity Satisfied a Performance Obligation,” of FASB Accounting Standards Codification (ASC) Topic 606:
For aerospace and defense entities, a careful evaluation of the facts and circumstances is required to determine which method best depicts the entity’s performance in transferring control of goods or services to the customer. The entity should carefully consider the nature of the product or services provided and the terms of the customer contract, such as contract termination rights, the rights to demand or retain payments, and the legal title to work in process in determining the best input or output method for measuring progress toward complete satisfaction of a performance obligation.
As the nature of aerospace and defense service contracts varies widely, the selection of the best method of measuring progress toward complete satisfaction of a performance obligation requires knowledge of the services provided to the customer as well as the contractual terms of the performance obligation, particularly those terms involving the timing of service delivery.
Aerospace and defense companies should consider whether the practical expedient in FASB ASC 606-10-55-18 would be applicable for its service contracts that specify the right to invoice and the amount of the invoice corresponds directly with the value to the customer of the entity’s performance completed to date.
For certain service contracts, it may be appropriate to use an output method related to the number of instances homogeneous services are provided to the customer relative to the number of instances the services are expected to be performed over the life of the service contract.
For other service contracts it may be appropriate to use input methods for measuring progress towards complete satisfaction of a performance obligation depending on the facts and circumstances. FASB ASC 606-10-55-20 states that, “if the entity’s efforts or inputs are expended evenly throughout the performance period, it may be appropriate for the entity to recognize revenue on a straight-line basis.” In service contracts for which output methods are not an appropriate measure of the complete satisfaction of the performance obligation, and when the performance obligation is not satisfied evenly throughout the performance period, the cost-to-cost method may be more appropriate.
The following examples are meant to be illustrative of aerospace and defense service contracts for which the related performance obligations are satisfied over time. The actual determination of the method for measuring complete satisfaction of a performance obligation as stated in FASB ASC 606-10-25-31 should be based on the facts and circumstances of an entity’s specific situation.
Example: An aircraft maintenance provider may enter into a contract that provides routine daily maintenance for a fleet of aircraft for equal monthly payments over 24 months of service, with no contract provisions to adjust the transaction price based on the condition of the aircraft. The contractor may consider straight-line revenue recognition to be a reasonable depiction of the amount of the entity’s performance and transfer of control of the goods or services to the customer as the efforts are expended evenly throughout the performance period.
Example: The same aircraft maintenance provider may provide major aircraft maintenance overhauls. In this circumstance, the level of effort necessary for the overhaul varies depending upon the condition of the aircraft. In these circumstances, an input method, such as cost-to-cost may be a reasonable depiction of the amount of the entity’s performance and transfer of control of the goods or services to the customer.
Asset management preparers: This excerpt is relevant to Step 1: “Identify the Contract With a Customer,” of ASC Topic 606.
Step 1 of the five-step process for revenue recognition requires the entity to identify the contract with a customer. Determining which party is the customer is an important consideration.
The guide offers the following considerations on this topic for asset management financial statement preparers:
Entities will need to consider the specific facts and circumstances of each arrangement in evaluating whether the investor or the fund is the customer. To assist in this evaluation, the indicators below have been developed for use by the asset management industry and may be used as a framework to assist preparers in applying judgment to their specific facts and circumstances. These lists are not intended to be all inclusive and should not be viewed as checklists. The existence or absence of any one indicator should not be considered determinative. The substantive nature of indicators should also be considered. That is, weight given to the existence of any indicators should be commensurate with its meaningfulness in the context of the given contract. For example: The existence of a manager removal right could reflect either legally imposed restrictions or an investor’s influence over the terms of the contract. Judgment will need to be applied and weights attributed to the indicators based on relevant facts and circumstances.
FinREC believes the following characteristics may support a conclusion that the fund is the customer:
a. The fund is a separate legal entity that may be set up as a partnership, corporation, or business trust.
b. The fund is governed by a board of directors or other form of governance, which is independent of management of the fund.
c. Fee arrangements for management/advisory fees are negotiated by the fund and applied consistently by investor class.
d. A large number of potentially diverse investors is an indicator that the asset manager’s relationship is more directly with the fund.
e. The fund lacks visibility as to who the ultimate investor is because investors have subscribed through a third-party broker-dealer’s omnibus account.
f. The fund is highly regulated, as is the case with registered investment companies in the U.S.
g. The asset manager and other service providers may have multiple different contractual arrangements with the fund to provide different services.
An example of a situation in which a fund is the customer would be a registered investment company with hundreds of investors, including relationships through omnibus accounts, whereby none of the investors are deemed to have influence over the contracts between the funds and their service providers.
Conversely, in certain situations, the investor (or investors) may be the customer if one considers the relationship holistically. FinREC believes that the following characteristics may suggest that the investor (or investors) is the customer:
a. The asset manager enters into individual “side letter” arrangements regarding management fees with individual investors (as may be common in certain partnership structures).
b. There is active negotiation of fees or interaction between the asset manager and individual investors or a small group of investors that control the fund’s activity directly or indirectly through their role on the board or governing body (that is, the investors as a group act together as the fund’s governance structure).
c. The fund is not governed by a board of directors or other form of governance, which is independent of management of the fund.
d. There is a single or limited number of investors.
An example of a situation in which an investor may be considered the customer is a single investor fund where the investor has influence over the service arrangements, including pricing, and the design of the fund provides for no corporate governance through a board of directors or other form of governance, which is independent of management of the fund.
Auditors
The guide states that obtaining an understanding of the entity and its environment, including its system of internal control is a continuous, dynamic process of gathering, updating, and analyzing information throughout the audit.
According to the guide:
The auditor’s understanding of the entity and its environment consists of understanding the following aspects:
- Industry, regulatory, and other external factors.
- Nature of the entity.
- Objectives and strategies and the related business risks that may result in a material misstatement of the financial statements.
- Measurement and review of the entity’s financial performance.
- Selection and application of accounting policies.
- Whether principal and agent issues or licensing issues may exist in business transactions and how management has analyzed their effects, if any, on revenue recognition.
With regard to assertions about revenue, the auditor may consider obtaining information related to the following matters:
- The nature and extent of an entity’s performance obligations, including types of products and services sold.
- The effects of licensing agreements or the existence and effect of principal/agent issues.
- The types of contracts, including oral or implied contracts, and whether changes can be made to standardized contracts.
- Whether seasonal or cyclical variations in revenue may be expected.
- The sales policies customary for the entity and the industry.
- Policies regarding pricing, price concessions, sales returns, discounts, extension of credit, contingencies, and normal delivery and payment terms.
- Who, particularly in the marketing and sales functions, is involved with processes affecting revenues, including order entry, extension of credit, price concessions, and shipping.
- Whether there are compensation arrangements that depend on the entity’s recording of revenue. For example, whether the sales force is paid commissions based on sales invoiced or sales collected, and the frequency with which sales commissions are paid, might have an effect on the recording of sales at the end of a period as well as on how the entity measures, analyzes, and reviews its financial performance to identify the internal and external pressures on the entity.
- The classes and categories of the entity’s customers, including whether there are sales to distributors or value-added resellers or to related parties. If sales to distributors are material, it is important to understand whether concessions have been made in the form of product return rights or other arrangements in the distribution agreements the entity has entered into. Distribution agreements in the high-technology industry might include such terms as “price protection,” “rights of return for specified periods,” “rights of return for obsolete products,” and “cancellation clauses such that the real substance of the agreement is that it results in consignment inventory.”
- The nature and frequency of contract or revenue policy modifications.
The AICPA guide is available for purchase at aicpastore.com.
—Ken Tysiac (kenneth.tysiac@aicpa-cima.com) is a JofA editorial director.
