The 1st of January saw the UK GAAP Accounting Standards for revenue recognition change. These changes bring them in line with international accounting standards for revenue recognition for contracts with customers. The new standard brings in a principle-based approach which consists of a 5-step model for recognising revenue when the ‘performance obligation’ has been met.
The changes can be tricky for manufacturing companies to distinguish the revenue from contracts to the specific performance obligations, as these contracts typically include multiple promises.
What is a performance obligation?
A performance obligation is a promise in a customer contract to transfer either a distinct good or service or a series of goods or services.
A good or service can be seen as distinct if:
- The customer can benefit from it on its own
- The promise to transfer it is separably identifiable from other promises in the contract
Revenue is recognised when the control of that good or service passes to the customer.
What is the new 5 Step Model?
Identify the contract with a customer
- The agreement for the goods or services that creates forceable rights and obligations.
Identify the performance obligation
- Revenue must be allocated to the distinct goods or services set out in the contract as promised.
- For manufacturers, this could involve splitting out delivery of goods, warranties and installations.
Determine the transaction price
- This is the amount of consideration to which you expect to receive for transferring the good or service as promised to the customer
- It may include variable consideration such as volume rebates, in which case you should use the most likely amount.
Allocate the transaction price to the performance obligations
- Judgement for the allocation of the consideration may be necessary for any bundled pricing, for example selling a product with a warranty, which isn’t priced seperately.
Recognise revenue when the performance obligations are satisfied
- The revenue should be recognised when the specific performance obligation as set out in the contract has been satisfied.
- For example, installations may be recognised over time, whereas a sale of a product will be recognised when this is transferred to the customer.
Potential challenges for manufacturing companies
There could be significant complexities for manufacturers when considering their revenue recognition which will make the new standards more challenging, some of the key challenges include:
- Estimating variable consideration
- Multiple performance obligations in single contracts
- Long term contracts and percentage of completion calculations for installation
- Bespoke manufacturing contracts
- Judgement based decisions
- Contract modifications
What is the impact on financial statements?
Since the new standard could impact the timing of revenue, this could materially impact the results of the company, the following could be impacted because of the changes:
- Profitability margins in a financial period
- KPI’s
- Cut off adjustments for purchases and WIP
It is possible that after assessing revenue under the new five step model that there is no material impact to the revenue recognition of your business, but it will take time to assess and conclude.
What steps can you take to prepare for this?
- Review contracts with customers to split out the promises and the price for each
- Update templates for new contracts that clearly distinguish each performance obligation
- Update pricing terms
- Communicate with stakeholders the potential changes to timing of revenue in the accounts
- Implement new systems to help calculate price splits in contracts
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