I’ll say this once, say it twice, and then say it three times: the ultimate goal of the FASB’s Accounting Standards Update ASC 606, is to provide a more consistent and comprehensive view of financials on both the national and international platforms to the users of financial statements (meaning we, the people).
Remember when we wrote the blog that highlighted an ability to derive value from the implementation of automatic revenue solutions? Well, in case you missed it, many businesses may have lost preliminary opportunities to transform business practices while implementing the new revenue guidance, ASC 606 Revenue from Contracts with Customers, simply because they were ill prepared.
“In an interview at the Financial Executives Internationals Current Financial Reporting Issues conference in New York, John McGaw, the Americas accounting change leader at Ernst & Young, was quoted saying ‘Companies that became involved earlier in the process found ways to drive other business benefits from the adoption of the new standard. If the revenue automation or enhanced processing technology can drive more efficient, faster, well controlled external financial statements, they’re also seeing ways to drive management reporting and better business insights from the process.’ This implies those transformative business opportunities can be derived from the implementation of automated revenue management solutions.”
While the majority of public companies are scooting past the ASC 606 compliance deadline with the bare minimum, there are a few who were not so lucky. Not to highlight those less fortunate, but the investigation into GE’s revenue management practices serves as a great example of how the new revenue guidelines are changing the game in understanding business financial statements.
The presentation of revenues down to the Contract Assets and Contract Liabilities level presents a truer depiction of revenue recognition and outstanding business obligation. In the case of GE, the Contract Assets continued to grow well past the Account Receivable, ultimately ballooning the financials into a false sense of security. This threw a red flag to the investors.
Hold up; back up, what do you mean “Contract Assets and Contract Liabilities”? So glad you asked. Our friends at RevenueHub said it best. Contract Assets, as defined by the new guidance, ASC 606-10-45-3, are “an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer” that is conditional on something other than the passage of time. And how is that different from Accounts Receivable you may ask? The receivable is booked when the right to payment is unconditional.
Need an example? Try this one – in January, a contract between Customer and Seller is signed. The contract states that Customer is purchasing two items, Product A ($40) and Product B ($60), and that the customer will pay the promised consideration ($100), once both Product A and B are received. In February, the seller delivers Product A. In March, the seller delivers Product B. The Contract Asset in this instance is $40 and created in February, when consideration for the promised good is still contingent on the delivery of Product B (not on time). The Contract Asset then turns into a Receivable in March, when both products have been delivered, and consideration is now unconditional.
Contract Liabilities are “an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or an amount of consideration is due) from the customer.”
Now consider how this ultimately affects the financial statements. Because again, the idea is to provide a more comprehensive view of a company’s financials to the users of the statements. At a high level, the addition of “Contract Assets” and “Contract Liabilities” will provide context for what is happening within the contract terms. At a more detailed level, these accounts ultimately determine how revenue will be hit the ledger, and at what amounts.
This new level of detail should help investors and shareholders better understand a company’s business position. In combination with the new disclosures requirements, Contract Assets and Contract Liabilities accounts will bolster the detail provided to clearly understand what’s going on underneath the hood of what used to be financial statements, and let the numbers speak for themselves.