Two Choices for Transitioning to ASC 606 – and Each One Isn’t Easy
It’s time to help your clients decide how they’ll transition to FASB’s new revenue recognition standard (ASC 606). Public companies need to adopt it for periods starting after Dec. 15, 2017, while non-public companies get another year. I wrote about the standards in general here and here, and about contract costs here.
The standards provide two basic options for transition: the modified recognition method (also known as the cumulative effect adjustment method) and the full retrospective method. FASB has provided several practical expedients, but your clients will still have plenty to do.
Modified Recognition Method
Under this method, ASC 606 is applied on a go-forward basis to all contracts initiated on or after the effective date, which is the date a company elects to adopt it. Under this method, any prior periods presented in the financials are reported under the old standards, and a single adjustment is made to equity for the transition year.
Let’s look at how this would affect a hypothetical company. GiggleMore is a private company that creates humorous greeting cards. Management has decided to adopt ASC 606 early, beginning on Jan. 1, 2018.
GiggleMore’s 2018 comparative financials, which include the two prior years, would show a single adjustment to equity at the beginning of 2018. This adjustment shows the cumulative impact of applying ASC 606 to either (a) contracts that weren’t completed as of 1/1/18 or to (b) all contracts for all years presented. GiggleMore’s 2016 and 2017 financials won’t change.
For these purposes, FASB defines a completed contract as follows: “A completed contract is a contract for which all (or substantially all) of the revenue was recognized in accordance with revenue guidance that is in effect before the date of initial application.”
GiggleMore’s finance team will need to analyze the contracts in progress at 1/1/18. These contracts may need to be broken up into separate performance obligations, with the contract price allocated to those separate obligations.
This method is simpler than the full retrospective method, as we’ll see below, but it does require additional disclosures. Those additional disclosures will provide a line-by-line analysis of the impact of ASC 606 in the 2018 financials, as well as discussion of any significant changes for prior periods, as previously reported.
These additional disclosures mean that companies will need to keep their books under both methods for the first year of implementation, or have some way of calculating the differences. Private companies seem to prefer this method because it’s less work.
Full Retrospective Method
Using this method, companies restate their financials for all periods presented as if ASC 606 had been in effect since the beginning of the first period. All contracts that are in progress during those periods are recast as if ASC 606 had always been in effect. Public companies tend to prefer this method because it’s best for providing the comparable information for their shareholders.
If GiggleMore chooses this method, they will make a single balance sheet adjustment to equity on 1/1/16 for the cumulative effect of the new standard for contracts in progress at that date. GiggleMore’s 2016 and 2017 financials will be restated to comply with ASC 606.
GiggleMore’s finance team will need to examine all contracts that weren’t completed by 1/1/16. FASB does offer several practical expedients to simplify implementation for short-term contracts, contracts with variable consideration, modified contracts and contracts for years prior to the company’s effective date.
If GiggleMore uses this method, they’ll have to keep their books under both methods for 2016 and 2017.
How to Decide?
With either choice, finance teams will have plenty of work ahead, as they analyze contracts and contract costs and set up systems to capture the needed information. Choosing the best method means considering the following factors:
- Comparability: How much information do investors and other stakeholders need? Comparing financials under the modified recognition method is harder, but if there aren’t many changes, the differences may not be material.
- Is historical information available? The full retrospective method means looking at more contracts, and those documents may be difficult to locate.
- How much time will this take? Smaller companies may not have the time or resources to do the full retrospective method.
- What will the material effect be? If there’s little impact on revenue or costs, the modified recognition method may be perfectly adequate.
Implementing this new standard means a steep learning curve for advisors and your clients. A good resource for learning more about the transition methods can be found in this report by KPMG, which also has plenty of examples, and two sample transition plans.