A New Revenue Recognition Standard

The New Revenue Recognition Standard and the Aerospace and Defense Industry

By

Peter Mayman

A NEW REVENUE RECOGNITION STANDARD

In May 2014 FASB passed a new revenue recognition standard. The new revenue recognition standard, (ASU) 2014-09 (ASC 606), will be the required reporting standard for public companies beginning after December 15, 2016 (American Institute of Certified Public Accountants [AICPA], 2014). Nonpublic companies will have to follow the standard for annual reporting periods starting December 15, 2017 (AICPA, 2014). This new standard essentially converges FASB and IASB revenue recognition, and will be felt by companies in all industries. ASU 2014-09 will also increase the comparability of revenue recognition between industries and reduce the use of different accounting for similar transactions. Companies that currently follow industry-specific guidance will feel the greatest impact. This article will detail FASB’s new revenue recognition standard with a specific emphasis on sections of the revenue recognition standard that experts have deemed impactful to the aerospace & defense industry.

INDUSTRY-SPECIFIC GUIDANCE IS OUT, 5-STEP MODEL IS IN

This section will provide an overview of the new 5-step model of revenue recognition. Subsequent sections will show how the new model of revenue recognition will impact the aerospace and defense industry. The core principle of the new revenue recognition guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services (FASB, 2014). In order to achieve this core principle a company should take into account the following five steps.

Step 1: Identify the contract with a customer

A contract establishes the legal rights and obligations of the parties entering into an agreement (FASB, 2014). A contract exists if: there is commercial substance, both parties have approved it, it establishes both parties’ rights and obligations, it specifies payment terms, and it is probable that the seller will collect the agreed upon amount.

Step 2: Identify the performance obligations

A performance obligation is a promise from the seller to transfer a distinct product or service to the customer (FASB, 2014). If a contract includes more than one good or service then each product or service should be accounted for as a separate performance obligation if it falls under the following definition: The good or service is capable of being distinct and the good or service is separately. If a good or service does not fall under this definition then it should be placed with other promised goods or services until there is a distinct and separately identifiable package (FASB, 2014).

Step 3: Determine the transaction price

The transaction price is what the seller is entitled to receive from the customer in exchange for the good or service. When determining the transaction price the effects of variable consideration, time value of money, noncash payments, and payments to the customer should be taken into account (FASB, 2014). Variable consideration means that the price may differ due to the nature of the contract. If this is the case, the expected value or most likely amount should be used depending on which is more probable as long as a significant reversal in the revenue amount is not expected (FASB, 2014). The transaction price should take into account the TVM if there is a significant financing element to the contract. Noncash payments should be measured at fair value (FASB, 2014). Payments to the customer reduce the transaction price accordingly.

Step 4: Allocate the transaction price to the performance obligations

If there are multiple performance obligations within one contract, then the company providing the goods or services should allocate the transaction price to each separate performance obligation at the amount the company expects to receive for each performance obligations based upon each performance obligations stand alone price (AICPA, 2014).

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation

Revenue should be recognized at a point in time if control of the asset is transferred to the customer at a single point in time; If control of the asset passes to the customer over a period of time (customer consumption of asset/benefit as work is performed, customer control of asset as created, specialized asset/product that seller has right to receive payment for.

IMPACT OF NEW REVENUE RECOGNITION STANDARD ON THE AEROSPACE AND DEFENSE INDUSTRY

Although it is important to remember that all industries will be impacted by the new revenue recognition standard, this section will focus on the impact that experts in the field believe it will have on the aerospace and defense industry. Currently, most aerospace and defense companies use the percentage of completion revenue recognition guidance in ASC 605-35 (Ernst & Young [EY], 2014). The new revenue recognition standard will replace said guidance, which means that the aerospace and defense industry will be impacted accordingly.

The first area of interest for the aerospace and defense industry relates to the first step of the new five-step model for revenue recognition, identify the contract with a customer.

Currently, entities in the aerospace and defense industry enter into complex transactions with customers that could include numerous goods and services that may be formalized into one or more contracts (EY, 2014). For example, a current contract could include an agreement with a customer to purchase a certain amount of jet engines with the possibility of additional purchase orders of jet engines at a predetermined price that will take place in the future (EY, 2014). Conversely, a transaction that includes a customer ordering a product such as an aircraft along with complementary spare parts or maintenance agreements could be split into multiple contracts (EY, 2014).

The new revenue recognition standard provides guidance on when contracts with the same customer must be combined or not. Under the new standard, contracts must be combined when: the contracts have a single commercial objective, the transaction prices of the contracts are interdependent, or the promised goods or services in the contracts form a single performance obligation (EY, 2014). It should be noted that the preceding three situations will only cause contracts to be combined when the contracts are entered into at or near the same time and with the same customer. Also, a contract cannot be combined with anticipated contracts that do not currently establish enforceable rights and obligations (initial loss-leader contracts) (EY, 2014).

The second area of interest for the aerospace and defense industry relates to the second step of the new five-step model for revenue recognition, identify the performance obligations.

It was established in the first area of interest for the aerospace and defense industry that contracts must be combined when the goods or services in the contracts form a single performance obligation. This section will go into further detail about identifying performance obligations as it relates to the aerospace and defense industry and their impacts on contracts. This will be done by examining a hypothetical situation that is common in the aerospace and defense industry.

There are many instances in the aerospace and defense industry when there are multiple goods or services involved in a single transaction. The new revenue recognition standard says that these goods or services must be identified as either a single performance obligation or multiple performance obligations (Stallings, de Grissac, Coleman, & Dipillo, 2014). A common example of when entities in the aerospace and defense industry must determine if there are multiple performance obligations occurring in a transaction is when they have to determine whether or not the design and the build of an aircraft represent a single performance obligation or multiple performance obligations (Stallings et al., 2014). For example, if the customer can benefit from the design without actually receiving the built product there may be multiple performance obligations (Stallings et al., 2014). If the customer cannot benefit from the design without the build, then the build and design may not be distinct and separately identifiable – which would result in a single performance obligation.

The third area of interest for the aerospace and defense industry also relates to the second step of the new five step model for revenue recognition. The third area of interest is how to account for contract modifications under the new revenue recognition standard.

Contract modifications, or change orders, are very common in the aerospace and defense industry (EY, 2014). This seems to be a very intuitive concept. For instance, many products in the aerospace and defense industry can take long periods of time to build. This can cause customers to have additional needs/requirements for the product than when they originally ordered it (governments may need more advanced technology than originally thought due to unforeseen developments).

Current industry guidelines state that a contract modification is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured (Stallings et al., 2014). The new revenue recognition standard states that revenue from a contract modification is not recognized until it is approved (Stallings et al., 2014). Also, the new revenue recognition standard requires distinct contract modifications to be accounted for prospectively (EY, 2014). This will represent a change for the aerospace and defense companies that currently use a cumulative catch-up basis to account for distinct contract modifications (EY, 2014).

The fourth area of interest for the aerospace and defense industry deals with the third step of the five-step model of revenue recognition, determine the transaction price. Specifically, the impact of variable consideration on the transaction price.

The impact of variable consideration on the transaction price will be felt throughout the aerospace and defense industry. Contracts that include award or incentive fees are commonplace in the aerospace industry (Stallings et al., 2014). Such fees would be considered variable consideration. Current industry guidelines state that awards and incentive payments are recognized as contract revenue when the payments are probable and can be estimated (Stallings et al., 2014). The new revenue recognition standard states that the variable consideration can be included in the transaction price up to the amount for which it is probable a significant revenue reversal will not occur when the variable consideration is resolved (EY, 2014).

The fifth area of interest for the aerospace and defense industry also relates to determining the transaction price. Specifically, the impact of a significant financing component on the transaction price.

Entities in the aerospace and defense industries commonly have long-term contracts with their customers (Stallings et al., 2014). This is intuitive, as it takes long periods of time to build many of the products associated with the aerospace and defense industries. Long-term contracts often include a significant financing component. Under the new revenue recognition standard, contract revenue should reflect the time value of money if the contract includes a significant financing component (Stallings et al., 2014). A significant financing component is likely unless the difference between when the goods/services are delivered and payment from customer is under one year (FASB, 2014).

The sixth area of interest for the aerospace and defense industry relates to the fourth step of the five-step model of revenue recognition, allocate the transaction price to the performance obligations.

There are many instances when a company in the aerospace and defense industry would have to allocate the transaction price of a contract to the different performance obligations involved in said contract. It is common practice in the aerospace and defense industry to negotiate contracts that involve more than one performance obligation. Currently, separately negotiated prices for goods and services are used as the value of said contract components (EY, 2014). Under the new revenue recognition model, the transaction price is allocated using the stand alone selling price of the good or service. There are numerous methods available to estimate the stand alone selling price of the good or service under the new revenue recognition model. These methods include the adjusted market assessment approach, the expected cost plus margin approach, and the residual approach.

The seventh and last area of interest for the aerospace and defense industry discussed in this article relates to the fifth and final step of the five-step model of revenue recognition, recognize revenue when (or as) each performance obligation is satisfied.

Currently in the aerospace and defense industry revenue is recognized using the percentage of completion method (Stallings et al., 2014). This method would be reasonable if the performance obligation is satisfied over a period of time. This would be the case if the customer has right of use while work is being performed, the customer controls the asset as it’s created, or the seller is creating a specialized product with no other use and has the right to receive payment for work completed. If the customer does not have these rights then revenue will most likely be recognized at a single point in time. There are many instances in the aerospace and defense industry when customers, such as the government, do have the right of use or control of an asset during creation. Some products in the aerospace and defense industry are also very specialized and have no other use to anyone but the customer who ordered the product. This is not always the case though, so the new revenue recognition standard could have a great impact on the industry as it relates to the timing of said revenue recognition.

Bibliography

American Institute of Certified Public Accountants. July 2014. Roadmap to understanding the new revenuerecognition standards. Retrieved from http://www.aicpa.org/InterestAreas/FRC/AccountingFinancialReporting/RevenueRecognition/Downloadab leDocuments/FRC_Brief_Revenue_Recognition.pdf

Financial Accounting Standards Board. May 2014. Accounting standards update. Retrieved from https://asc.fasb.org/imageRoot/00/51801400.pdf

PricewaterhouseCoopers. March 2014. 10 minutes on revenue recognition. Retrieved from http://www.pwc.com/en_US/us/10minutes/assets/pwc-10minutes-on-revenue-recognition.pdf

Ernst & Young. September 2014. The new revenue recognition standard – aerospace and defense. Retrieved from http://www.ey.com/accountinglink

Stallings, D, de Grissac, A.J., Coleman, M, Dipillo, D. July 2014. Revenue from contracts with customers. Retrieved from http://www.pwc.com/en_US/us/cfodirect/assets/pdf/in-depth/2014-01-revenue-recognition-ad-supplement.pdf