As private companies are now a few years into the implementation of Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, it is important to note the impact this has had on the manufacturing industry and understand the changes to revenue recognition so owners may better operate their businesses.
By definition, a manufacturer should recognize revenue from customers in an amount that reflects the consideration which it is expected to be entitled in exchange for goods and services. The five-step process for valuing the amount recognized involves the following:
- Identifying the contract with a customer.
- Identifying the performance obligations in the contract.
- Determining the transaction price.
- Allocation of the transaction price to the performance obligation in the contract.
- Recognizing revenue when the company satisfies a performance obligation.
The principal change to revenue recognition as it pertains to ASC 606 requires manufacturers to evaluate whether a contract is completed over time or at a point in time.
For manufacturers who produce highly customized products built to customer specifications, this means potentially recognizing revenue through the measurement of progress using acceptable input or output methods, such as the percentage of completion method. Revenue is required to be recognized if customized goods have no alternative use to the manufacturer and the company has a right to payment for performance completed to date. It’s very important to note that a manufacturer has a right to payment if it were entitled to receive compensation for work performed to date, even if the customer were to terminate the contract for reasons other than failure to perform. Many manufacturers fall into this category, and determining a methodology for measuring progress during the manufacturing process should be established in order to appropriately recognize revenue and related expenses. Ultimately, this results in many companies recognizing revenue earlier than they would have under previous accounting standards, and effects both the income statement and balance sheet, along with other tax implications.
If not satisfied over time, manufacturers will recognize revenue at the point in time in which control of the goods or services is transferred to the customer. Legal title, physical possession, right to payment and customer acceptance need to be evaluated to determine when the point in time actually occurs in order to recognize revenue.
Volume discounts, warranties, customer acquisition costs, variable consideration, tooling and setup costs are other areas that also impact how revenues are recognized under 606, and should be considered when entering into new contracts with customers. Analysis should be performed on an individual contract basis and internal policies and procedures should be established so a company is in a position to maximize the benefit of the contracts they enter into with customers.
Please contact your trusted TBC Advisor for more information about the impact that these revenue standards may have on you.