Contract Analytics and the New Revenue Recognition Regime

Although the guidance surrounding the new revenue recognition rules is not new (FASB issued the guidance in ASU 2014-09 more than 3 years ago), the first deadline for compliance is quickly approaching. Public companies must follow the new guidance for reporting periods beginning on or after January 1, 2018. All other entities must follow the new guidance starting the following year (January 1, 2019). Any entity that executes contracts with customers is subject to the revenue recognition rules under ASC 606, except for excluded types of contracts. Insurance contracts are one such example, and are controlled by ASC 944 (registration is required for this site).

The Nitty Gritty Rules of ASC 606

To briefly summarize the guidance, the following steps should be taken in order to determine appropriate revenue recognition:

  1. Identify the Contract and Customer. This sounds like a basic step, but gathering all contracts can be a difficult undertaking for many companies. This is especially true if a good contract management system isn’t in place. Furthermore, it can be challenging to determine who the customer is when multiple parties are involved in a contract.
  2. Identify Performance Obligations. Distinct performance obligations must be separately identified, while performance obligations that are substantially similar (and follow the same pattern of transfer to a customer) should be grouped together as a single performance obligation.
  3. Determine Transaction Price. The transaction price is based on the terms of the contract, as well as customary business practices. This is not as simple as reviewing a few lines in an agreement, since the following matters may influence the transaction price:
    1. Variable consideration
    2. Constrained estimates of variable consideration
    3. Existence of a significant financing component
    4. Non-cash considerations
    5. Consideration payable to the customer
  4. Allocate Transaction Price. The transaction price should be separately allocated to each specific performance obligation. This is determined on the basis of the consideration for which the entity expects to receive for the performance of each obligation. Discounts, allocation of variable consideration, and any changes in the transaction price must be accounted for as part of this step.
  5. Recognize Revenue When Performance Obligations are Satisfied. Performance obligations may be satisfied over time, at a specific point in time, or immediately upon transfer of a good. There are a number of different methods that can be used to measure satisfaction of a performance obligation over time. For the sake of brevity, we will not discuss them as part of this post.

What Does Implementation Look Like?

New rules are fine, but what does it actually take to implement the revenue recognition guidance? The biggest factor in the cost and time required to implement the guidance likely relates to a company’s contract management system. If contract management is fragmented throughout the company, the process will be difficult. In a recent webinar by PwC, 40% of attendees indicated that process and system changes were the biggest challenge to implementing new guidance. In this same group, over 35% of respondents indicated that the cost of implementing these changes would exceed $500,000. This comes as no surprise; the five steps outlined above all rely on access to contracts themselves. If companies cannot easily manage, or even find their contracts, then they cannot efficiently and properly recognize revenue.

There are a number of ways to approach the contract analysis process. Solutions range from completely outsourcing the task, to developing internal teams comprised of accounting members and subject matter experts. If contracts are negotiated in a standard manner (or using standard terms), the process is significantly streamlined. This is rarely the case for all contracts in a company, though. Contracts that are individually negotiated may require more analysis.

Large public companies have likely already begun undertaking the systematic and cultural changes that are required to implement the revenue recognition guidance. That said, it isn’t too late to begin addressing the needs of your company.

How ContraxSuite Can Help

So far, we have highlighted the two key beginning steps of any revenue recognition exercise:

  • Identify the Contract and Customer.
  • Identify Performance Obligations.

Our open source contract analytics platform, ContraxSuite, is designed to solve problems like these. Many organizations may struggle in their effort to find all relevant contracts. We solve this problem by helping organizations identify, organize, and de-duplicate their contracts. ContraxSuite comes with connectors that can communicate with network drives, email servers, and cloud services like Office 365 or Google Apps. ContraxSuite also utilizes classifiers and clustering algorithms to quickly find and group contracts by type.

Once all relevant contracts are identified, built-in ContraxSuite algorithms can locate parties, dates, financial terms, and key clauses like payment terms, support periods, or deliverable conditions. Our developers can use hundreds of thousands of agreements in our database of publicly-traded company documents to help build accurate and comprehensive review systems.

Organizations can also customize processes in ContraxSuite to fit their review workflows and capture evidence to substantiate changes in recognition models.

In addition to the use of a contract management system, a number of other factors may improve your company’s success in implementing these rules. First, it is helpful to have a single project manager who oversees the process. This person should work with the internal teams (accounting, internal audit, subject matter experts, IT) and external teams (consultants, tax accountants, auditors) to ensure completion of all steps in the process. It is important for these teams to work together. It is particularly useful to have subject matter experts work with IT to ensure that the systems that are developed capture the appropriate information. Finally, given the far-reaching implications of these rules, it will be helpful to embed any new processes in the entire organization, rather than limiting them to a single department.

What to Expect

The unexpected! With financial accounting standards, there are always new changes on the horizon. Although it can be difficult to guess what the FASB may come up with next, they generally offer reasonable implementation timelines. In the case of ASC 606, the deadline is nearly here, but there will certainly be updates and changes down the road. Some suggest keeping your friends close but your enemies closer; for contract management, we recommend keeping your lawyer close and your contract data closer.