Revenue Recognition Procedure Changes Food & Beverage Companies Should Watch Out for Due to ASC 606
In May 2014, the Financial Accounting Standards Board (FASB) issued a new accounting standard which changed the way revenue is recognized and disclosed in financial statements. Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, is effective for public companies with annual reporting periods beginning after December 15, 2017 and non-public entities with annual reporting periods beginning after December 15, 2018.
Previously, there was no comprehensive guidance related to revenue recognition, but revenue was typically recognized when risk of loss was transferred to the customer, or when persuasive evidence of a sale had occurred.
The new guidance applies a five-step model for recognizing revenue which focuses on control of a good or service. They are:
- Identify a contract with customer, which is defined in the standard as “an agreement between two or more parties that creates enforceable rights and obligations.”
- Identify performance obligations, which is the promise (or promises) to a customer in a contract.
- Determine the transaction price, including any variable costs or other contract costs.
- Allocate the transaction price to each performance obligation based on the standalone selling price of each performance obligation.
- Recognize revenue at either a point in time, or over time, based on when the performance obligations are satisfied.
How does this affect food and beverage companies? The update does not drastically change revenue recognition in the sector as compared to software or construction, but there are some components of the standard that directly affect food and beverage companies, especially related to presentation and disclosure in the financial statements. While the majority of food and beverage companies will continue to recognize revenue at a point in time when the sale occurs, it is imperative for entities to understand the new standard in order to determine what aspects apply to them.
Shipping and handling activities in the new guidance may result in changes in revenue recognition. Under previous guidance, shipping and handling revenue would typically be included as part of the sale and the related expense would be included as a distribution expense. Under the new guidance, if control of inventory sold to a customer is transferred prior to shipment, but the company has agreed to ship the goods, the related shipping and handling activity should be recorded as its own performance obligation, with revenue recognized separately from the sale of the inventory items.
It is important to note that if the total revenue is deemed immaterial by management for the shipping and handling income, the revenue does not need to be recorded as its own performance obligation.
Additionally, management will need to determine if they are the principal or an agent on these activities to determine if shipping and handling would be recorded on a gross or net basis with the related shipping expense.
Typically, if the company is an agent, these activities would be recorded on a net basis with the related costs. If control of the goods stays with the company until delivery, the shipping and handling costs are not a separate performance obligation, as they are part of the order fulfillment.
ASC 606 has included a policy election that allows entities to include shipping and handling activities that occur after the customer has obtained control as part of the fulfillment cost. This election should be disclosed in the financial statements, if material, and must be consistently applied from year to year.
Variable costs are an important component of ASC 606 when determining the transaction price of the revenue recognition. These encompass many items such as slotting fees, volume discounts, rebates, incentives, credits, returns, etc. Variable costs should be estimated at the time of the contract and reduce the transaction price recorded as revenue with a corresponding payable recorded on the balance sheet.
Although many of these costs have typically been included as a reduction to sales under the previous standards, the new guidance specifically addresses them as they relate to revenue recognition, stating that they should be estimated and recorded at the time of the sale.
Sales incentives (including coupons, volume discounts, and rebates) should also be evaluated by management for revenue recognition under ASC 606.
Prior to the new standard, an estimate for sales incentives would be accrued as a liability during the financial close, if material. As part of the new guidance, management should determine if these sales incentives create a separate performance obligation. This would occur if the sales incentive provided the customer with an option that is a material right they would not have had without entering into the initial contract.
Material rights generally relate to options to purchase additional goods at a discount. For example, coupons may be considered such an option, and could create a separate performance obligation. If management has determined that the sales incentives are separate performance obligations, the amount of the sales incentive would need to be recorded to revenue or deferred revenue each time a product is sold.
Expected returns are addressed under the new standard as well. The transaction price is reduced, and a refund liability is required to be recognized for any material amounts expected to be refunded to the customer. This liability can be based on historical information or other factors as defined in the guidance. There is a corresponding asset recorded that represents the entity’s rights to the goods expected to be returned, which is the value of the inventory sold, less any restocking fees.
ASC 606 also addresses the incremental costs to obtain a contract (for example: sales commissions), stating that they are required to be capitalized on the balance sheet as an asset if those costs would not have been incurred had the sale not taken place. The requirement to capitalize these costs and amortize over the contract period is waived if the amortization period is less than one year.
The quantitative and qualitative disclosures related to revenue presentation and disclosures have been expanded, with fewer disclosures required for non-public entities. ASC 606 requires disclosures on the disaggregation of revenue, performance obligations, significant judgements, assets recognized to obtain a contract, and other factors.
For many entities, these changes require adjustments to previously issued financial statements. The FASB has allowed entities to reflect these adjustments either through the full retrospective or modified retrospective methods. The full retrospective approach would re-state each prior period presented in the financial statements. The modified retrospective approach reflects the transition to ASC 606 for the most recent year presented and includes disclosures on the impact on those financial statements.
ASC 606 has changed revenue recognition for many companies. For more information about how the new revenue recognition standard may impact your company, please contact Mazars USA.