April 19 by Sarah Van Caster
It’s 1985. You’re cruising in your Ford Fiesta, jamming to “Su-su-ssudio!” and heading to Back to the Future for the third time. Life is great. You have a decent job with a good pension plan. What you do not know is, although Back to the Future and Phil Collins will both stand the test of time, your pension will not. One small accounting rule will change the way the entire country saves for retirement. The new standard requires companies to change how they account for their pension plans, suddenly making pensions far more expensive. Many companies will choose to phase out pensions and introduce defined contribution plans, the most popular of which are 401(k) plans. This simple accounting change (FAS 87) created a $4.7 trillion 401(k) industry and impacted 80% of the US workforce.
Fast-forward to 2017: your retirement plan has shifted to a 401(k) plan, which works for you and the movies you see are now controlled strictly by your children. And, another major accounting rule is about to make a splash in the business world. Coming just in time for the holiday season this year is the new ASC 606 regulation that will standardize how companies recognize revenue from customer contracts. This change is going to have a global impact on public and private companies. You may be questioning whether this rule will have any impact on you, but if you affect your company’s revenue, handle contracts in any way, or if you are responsible for acquiring customers, you need to understand the implications of this rule. Here is what you need to know:
What is ASC 606?
ASC 606/IFRS 15 accounting standards promise international alignment on how companies recognize revenue from contracts with customers. The guidelines are about the results of your end-to-end processes starting with contracts, through pricing, quotes, orders, and ending with revenue recognition. The full name of the rule is ASC 606: Revenue from Contracts with Customers. In the US, this rule was issued by the Financial Accounting Standards Board (FASB). This organization maintains this country’s gold standard for accounting, Generally Accepted Accounting Principles (GAAP). Private companies are not required to use GAAP standards, but as a general practice, many do to adhere to best practices and encourage external investment. Outside the US, there is an organization called the International Accounting Standards Board (IASB) that works to standardize accounting rules across dozens of other countries. The FASB and IASB work together. The IASB is issuing IFRS 15, which is essentially the same rule as ASC 606, giving this change global implications.
“By establishing comprehensive principles, the boards hope that preparers around the globe will find revenue guidance easier to understand and apply.”
2014 joint standard statement from the FASB and IASB
ASC 606 is all about revenue recognition, a process which is historically inconsistent across companies and industries. It is variable because it is messy. Recognizing revenue often has many different factors coming into play throughout the lifecycle of the sale – subscription models (monthly fees vs. up-front costs), product and service bundling, termination fees, rebates, warranties, shipping, etc. If you are an organization that processes millions of transactions or generates billions of dollars, you can see where these seemingly endless combinations of revenue recognition can get tricky. The bottom line is rules on revenue recognition have not been strong enough, but the accounting gurus have acknowledged this and ASC 606 is the answer to this current financial challenge.
ASC 606 Effective Date
US GAAP requires public entities to apply the revenue standard for annual reporting periods (including interim periods therein) beginning after December 15, 2017, and permits early adoption a year earlier (that is, for annual periods beginning after December 15, 2016).
Nonpublic entities reporting under US GAAP are required to apply the revenue standard for annual periods beginning after December 15, 2018. Nonpublic entities reporting under US GAAP are permitted to apply the standard early; however, adoption can be no earlier than annual reporting periods beginning after December 15, 2016.
Entities that report under IFRS are required to apply the revenue standard for annual reporting periods beginning on or after January 1, 2018, and early adoption is permitted.
Impact Across the Business
For most in finance, ASC 606 will have a direct impact to some daily tasks. Typically, revenue recognition rules were specific to an industry, at least to an extent. With ASC 606, these rules are now more general. This means finance resources will not need to necessarily have as deep industry knowledge as was once required, but they do need to learn ASC 606 inside and out. Financial resources will also need to spend more time strategizing around contracts and doing this work may require new skills for some. ASC 606 will make revenue recognition calculations more complicated, potentially requiring new systems to help with processing and forecasting. Quote-to-Cash technology will be more important than ever with these new standards. If a salesperson is negotiating a contract, how does he/she know if a change is better or worse in terms of revenue recognition? In order to make the right decision, the revenue recognition rules need to be baked-in to the product catalog, up-sell and cross-sell programs, contracts, and other areas of the sales process. Having a Quote-to-Cash solution in place is the best chance at achieving optimal outcomes for the business, while complying with ASC 606.
The major ASC 606 change for sales organizations is the need to align sales incentives (commissions, bonuses, etc.) with new revenue recognition policies. For many salespeople, this will mean a direct impact to their comp plans – not necessarily positive or negative, but the ways people get incentivized will need to change. For example, if a salesperson is used to throwing in free “add-ins” to close a deal (think free support, extended warranties, waived fees, etc.), some of these items will now slow down revenue recognition with ASC 606, thereby hurting the company’s top line. You may no longer want salespeople using these types of “sweeteners” to close a deal. Conversely, there may be options that accelerate revenue recognition like offering higher commission payouts for high margin product sales, product bundles that include upfront purchases with subscription services or other programs that bring revenue in faster. The finance team will determine the best contracts, price bundles, service options, etc. that work with the new revenue regulations, but is up to the sales organization to sell products and services that provide the best revenue outcome. The best way to ensure salespeople do this is by implementing incentives that align with your corporate strategy. Incentive Compensation solutions can help align incentives and drive sales performance and Configure Price Quote solutions can be leverage to guide salespeople to build quotes that are ASC 606 compliant and optimal for business outcomes.
The legal department’s job as it relates to customer contracts is managing risk. In most companies, the commercial terms (sell price, discounts, length of contract, etc.) are worked out by the sales team before Legal ever gets involved. The customer agrees to these terms and then Legal reviews the contract. Legal then deals with the terms such as liability, privacy, termination rights, etc. With ASC 606, there is a new wrinkle: legal terms can now affect the deal value if they create or modify the performance obligations. According to the new rule, every separate and distinct obligation has to be considered in revenue recognition. This could include things that Legal adds or changes. For example, are there marketing considerations on either side? Is there a free consulting service included? Shipping? Additional fees? The value of a deal is now likely more than just sell price plus delivery terms agreed upon by the sales team and customer. The parts of the deal that only take shape in the written contract can now affect value by either slowing or speeding up revenue recognition for the entire contract. Bottom line: revenue recognition is now embedded in legal terms which requires much more detailed collaboration between Finance, Sales and Legal.
In the post-ASC 606 era, organizations will function best when Finance, Sales and Legal work more strategically together on customer contracts. Providing your teams with a common set of tools to follow a deal all the way from selling to revenue recognition is more critical than ever. Financial resources and legal teams need to collaboratively design and communicate optimal strategies and contracts and salespeople need to have incentives that align with those strategies. As you prepare for these changes, assess your current processes and systems, identify where changes need to occur and take actions now. By getting ahead of ASC 606, you will surpass your torpid competitors whose revenues will stall and set your organization up for long term success.