Do Your Manufacturing Contracts Contain Hidden Performance Obligations?
June 7, 2018
With the 2018 effective date for the new revenue recognition standard issued by FASB quickly approaching, SC&H Group has pulled together a comprehensive series of industry specific resources. The following blog post summarizes revenue recognition concepts specific to manufacturing contractors that must be considered to ensure their accounting policies are aligned with the FASB’s new standard.
Many companies are coming to the realization that FASB’s new model brings more judgment and estimation into the revenue recognition process, a concept that can make some accounting professionals uncomfortable. One of the key steps in the new approach for recognizing revenue is “Identifying Separate Performance Obligations in the Contract.” A performance obligation is defined as a promise to transfer a distinct good, service, or bundle of goods and services to a customer. Although the type and number of performance obligations inherent in a contract will vary based on each manufacturing environment, three key challenges emerged that require careful consideration for almost all manufacturers. These three challenges are discussed in further detail below.
Challenge #1: Shipping and Handling – All About Timing and Control
The treatment of shipping and handling depends on when the customer obtains control of the goods. A customer has control of an item if the customer can both (1) direct the use of the item and (2) obtain basically all of the remaining benefits from the item.
In instances where shipping and handling occur before the customer obtains control of the goods (i.e. FOB destination point), there will not be a change from current practice. A company will accrue the cost of shipping and handling and recognize revenue for the total value of the goods when control transfers to the customer (i.e. upon customer receipt). In this circumstance, the shipping and handling activity would be considered an order fulfillment process versus a distinct good or service (a requirement to meet the definition of a performance obligation).
Shipping and handling can, however, become a separate performance obligation under the company’s election if it occurs after a customer obtains control of the goods (i.e. FOB shipping point). In this situation, the company should allocate a portion of the transaction price to shipping and handling. As a result, revenue related to the goods would be recognized when control of the goods transfers to the customer (i.e. upon shipment). Revenue related to shipping and handling would be recognized as the shipping performance obligation is satisfied. The related expenses should be recognized as incurred. This election should be made consistently as a matter of company policy.
Challenge #2: Warranties – Service Warranties Requiring Careful Consideration
A standard product warranty which guarantees merchantable quality and functionality will continue to be accrued as a cost with no effect on revenue recognition.
Warranties that are priced through a separate arrangement, as typically seen in service type warranties, however, will require a change in accounting policy. A service type warranty is a promise to provide a distinct service and thus meets the criteria of a separate performance obligation. Under the new standard, service type warranties require revenue to be allocated to them on a relative stand-alone selling price basis. If the customer has the ability to purchase a service type warranty separately for a defined price, the company would account for the service type warranty as a separate performance obligation and recognize the revenue over the warranty period.
In instances where the manufacturer provides a service type warranty that is not separately priced, the company is still required to account for the service type warranty as a separate performance obligation and would be required to allocate a portion of the selling price to the service type warranty. The revenue associated with a service type warranty would need to be deferred and recognized over the warranty period.
Challenge #3: Volume Discounts – Retrospective vs. Future is the Key Differentiator
Determining whether or not a volume discount should be recognized as a reduction in the transaction price versus a performance obligation is determined on how the discount is applied.
Discounts that apply to all purchases under the contract once the volume threshold is achieved typically represent variable consideration. In this circumstance, the company would estimate the volume to be purchased over the life of the contract and reduce the contract’s transaction price by the amount of the overall discount estimate. The estimate would be updated throughout the term of the contract as necessary.
Discounts that only apply to future purchases after the volume threshold is achieved represent a separate performance obligation under the contract. The logic behind this is that the customer would not receive a right to the future discount without entering into the contract. Treatment as a separate performance obligation effectively allocates revenue that would be earned under the future discount option and defers this amount until the option to use the discount is exercised by the customer or expires.
By example, assume a contract with a customer provides the customer with the right to purchase the first 1,000 units at $10 per unit and any additional units at $9 per unit until the end of the contract period. The company would be required to estimate the total number of units that the customer will purchase during the contract period and calculate the average selling price under the contract. Revenue would be recognized based on the estimated average selling price. Management’s estimate of the average selling price should be reevaluated throughout the contract to determine if revenue should be revised.
Disclosure Requirements – What do Financial Statement Users Need to Know about Performance Obligations?
FASB’s new model includes a variety of disclosure requirements, one of which relates specifically to performance obligations. The goal of the expanded disclosures is to eliminate “boilerplate” language and instead provide a more meaningful description of revenue recognition policies and how they are applied to contracts with customers.
While the standard does not specify the level of detail required, manufacturers may want to consider disclosing the following information about their performance obligations, as applicable:
- The election to account for shipping and handling as a fulfillment cost versus a separate performance obligation
- The types of warranties associated with a product(s) and designation as a standard/assurance type warranty versus a service warranty
- Information regarding discounts and whether they are reflected as a reduction in the transaction price or a separate performance obligation
- Significant payment terms
- Obligations for returns and refunds
- Nature of the goods and/or services that are being transferred
Manufacturers should be evaluating their revenue streams and key contracts to identify components that may be considered performance obligations under the new standard. While this process is only one step in the five step model, a significant amount of judgment and decision making is required in both applying the standard and disclosing it’s impact.
Nonpublic entities are required to adopt the new standard for annual reporting periods beginning after December 15, 2018 (December 31, 2017 for public entities). Implementation is to be done on a retrospective basis, so organizations should understand and account for revenue under the new standard at least a year in advance.
As a result of these standards entities need to reassess their current revenue accounting and determine whether changes are necessary. SC&H Group is here to help as you are navigating the best next steps to pursue. If you have any questions about revenue recognition specific to the manufacturing industry Contact Us.