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I recently wrote about the challenge some companies will face in planning and budgeting when new revenue recognition rules go into effect in most countries in 2018. It’s important for companies that will be affected to be sure they have the appropriate systems, processes and training to handle the more difficult demands imposed by the new rules. With the change in accounting, the time lag between when a contract is signed and when a company recognizes revenue from it may be more variable and less predictable than in the past. In extreme cases, performance measured by financial accounting will diverge materially from the “real” economic performance of the organization. Consequently, executives – especially those leading publicly listed companies – will need the ability to look at their plans from both perspectives and be able to distinguish between the two in assessing their company’s performance. In companies where the timing of revenue recognition can diverge substantially from current methods, financial planning and analysis (FP&A) groups will need to be able plan using models that incorporate financial and managerial accounting methods in parallel. They will need to be able to identify actual-to-plan variances caused by differences in contract values booked in a period and differences between the expected and actual timing of revenue recognized from contracts signed in a period.
I don’t want to overemphasize the impact the new revenue recognition rules will have on companies’ planning. While some companies need to understand that they will have to alter their planning and review processes, I expect that most will be unaffected by the new accounting for contracts, for at least one of three reasons:
- A majority of their revenue does not come from contracts. (Retailing is one industry in which many companies do not transact business using contracts.)
- No single contract or type of contract is large enough to have a material impact on reported revenue.
- The time lag between signing a contract and fulfilling the contract is short (a month or less) or the time lag between booking a contract and fulfilling it is reliably consistent from month to month or quarter to quarter.
For many companies, tracking individual contracts will be unnecessary, impractical or both. It may be unnecessary because the relative size of contracts matters. Even if an organization’s individual contracts differ significantly in terms of the interval between signing it and recognizing revenue from the transaction, if there are enough of and even the largest represents an insignificant percentage of total revenue, the difference won’t matter. That is, in most cases the difference between expected and actual timing of revenue recognition of individual contracts is likely to be cancelled out. Moreover, tracking individual contracts will be impractical for many organizations because their volume will make it is too expensive and time-consuming to capture the relevant terms and conditions for each contract, which is necessary to be able to isolate the factors driving actual to forecast or budget variances. For FP&A groups the challenge will be in creating models that accurately forecast the average lag between contract signing and when revenue is recognized. Analysts also should confirm that the standard deviation of this lag under the new rules will be small enough to avoid the need to segment contracts into major types. (I’ll return to this point shortly.)
Nonetheless, a significant number of organizations – either entire corporations or business units with revenue responsibility – will need to change their approaches to creating and using planning models in order to accurately measure variances between their plans or budgets and their actual results. This means developing models that enable them to separate variances that are the result of differences in when business was booked and those in which the timing of the revenue recognition process turned out to be longer or shorter than expected. Certain types of businesses that have large, complex contracts with their customers, such as aerospace, construction and engineering, are likely to find that they need to plan and track results by contract – at the very least the 20 percent of their contracts that account for 80 percent of their revenues.
Another type of company or business unit that will need to adopt a more granular approach to tracking contracts under the new rules is one in which there are significant differences between the timing of revenue recognition for different types of contracts. Even though the value of individual contracts booked in a period is an insignificant percentage of the total, it may be necessary for organizations to segment contract bookings and revenue recognized for each major type of contract. This would be the case if there are significant differences in the timing of revenue between types of contracts and the mix of contract types varies from one month to the next. For example, imagine that Company X has contracts that have three distinct revenue recognition profiles. In one of them, which accounts for one-quarter of annual bookings, there is a consistent one-month interval between when the contract is signed and when revenue is recognized. For a second type of contract (representing 40 percent of annual bookings) it can take up to several months before revenue can be recognized, and then it happens all at once. The remaining contracts are recognized over a year after a contract is signed. Any significant differences in the mix of contract types signed from month to month will make it difficult to reconcile variances and accurately identify differences caused by better than expected or inadequate contract bookings and those caused by timing differences. So it’s necessary to create and use models that segment revenue by mix of contract types.
It is time for companies to get serious about adapting their business to the new revenue recognition rules. They will have to cut over to new processes and systems in 2017 to comply with the new standards and be able to make year-on-year comparisons when the new methods go into effect in 2018. Financial planning and analysis groups should be considering whether their forecasting, planning, budgeting and reporting models and processes will need to change under the new accounting standards. Those that will have to change should look into acquiring a dedicated planning and budgeting application if they (or affected business units) are currently using spreadsheets for planning. That will include many organizations: Our next-generation business planning research finds that two-thirds (65%) of companies use spreadsheets to manage their budget process. A dedicated planning application will help them prepare better to understand whether a difference was due to the new accounting rules or poor performance using actual data rather than opinions.
FP&A groups should be aware of their company’s exposure to new revenue recognition rules. If the rules will have a material impact on how the company accounts for contracts, they should determine whether it will be necessary to plan and budget for “real” and accounting data in parallel. If so, and if their company currently plans and budgets using desktop spreadsheets, I strongly recommend that they look into acquiring a dedicated planning application. In addition to dealing with increased complexity, this type of software can improve the budgeting and planning processes, making them more efficient.
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New standards governing accounting for contracts will go into effect for most companies in 2018. The Financial Accounting Standards Board (FASB), which administers Generally Accepted Accounting Principles in the U.S. (US-GAAP), has issued ASC 606, and the International Accounting Standards Board (IASB), which administers International Financial Reporting Standards (IFRS) used in most other countries, has issued IFRS 15. The two are very similar, and both will enforce fundamental changes in this area of accounting. Under the new approach to accounting for contracts, revenue (and some corresponding expense) is recognized only when customers are satisfied. In contrast, until now revenue was recognized when internally measurable events occurred, such as on delivery to the customer, the completion of milestones or the passage of time. In addition to dealing with an impact on accounting and planning, which I have discussed, companies may need to examine how the rules will affect how they account for commissions and other contract acquisition expenses.
The new accounting rules will affect all companies that enter into contracts with customers. For some (maybe a majority), the change will be more of form than substance. For them, the change can be handled readily by ERP and other accounting software that has been designed specifically to handle the new requirements. For instance, ASC 606 and IFRS 15 spell out a more elaborate, multistep process for booking contract revenue, but as I have noted, companies that design their contracting processes to facilitate accounting for them and use an application that automates the steps in the process will be able to substantially eliminate what otherwise would be an administrative burden.
On the other hand, the new accounting rules will have a significant impact on some corporations that use even moderately complex contracts in dealings with customers. They include, for example, contracts that are use tiered pricing or volume discounts, others that routinely involve modifications, such as adding or dropping services, or projects that require modifications in scope or term. Examples of the types of businesses most likely to be affected in this way include those in engineering and construction, ones that augment their products with recurring services as part of an ongoing relationship with customers (such as maintenance or consumable parts) and companies that offer subscription services that involve deliverables that can vary over time (such as units consumed or service levels).
The new standards also may affect how companies account for commissions. The new rules require companies to capitalize the incremental costs of obtaining a contract (such as sales commissions) at inception if the contract’s duration exceeds one year. This deferred expense is then amortized over the term of the contract so as to better match specific expenses to related revenues. However, not all expenses can be capitalized. For instance, compensation paid to supervisors, even when tied to sales volume, is expensed in the period incurred.
For contracts covering a year or less, companies will have to expense commissions immediately. It’s likely that auditors also will allow companies to immediately expense commissions and other contract acquisition costs even for contracts that extend beyond one year as an accounting policy election. However, this will be allowed only if a company applies this treatment consistently to all contracts with a term of one year or more and if the impact does not materially distort the financial statements.
Some companies may elect to expense all sales commissions immediately to keep things simple. This is more likely if a large majority of business done with contracts is fulfilled in one year or less; if commissions and other contract acquisition costs are relatively small; or if the company is closely held. However, others – especially publicly listed companies – may decide that capitalizing sales expense provides a more accurate picture of their financial performance, especially if comparable companies take this approach to their accounting. Under these circumstances, I recommend using sales compensation management software to track sales commissions. This type of application already offers considerable value to sales organizations. For companies that will capitalize commissions, sales compensation management software is likely to reduce accounting and auditing workloads substantially for those that have used spreadsheets to do it.
Our sales compensation management benchmark research finds that a large majority (71%) of companies use spreadsheets universally or regularly to manage their sales compensation process. Yet 61 percent of participants said that spreadsheets make it difficult to manage sales commissions, and nearly two-thirds (65%) said that the commission calculation process is too slow. Moreover, companies that capitalize sales expense and enter into even moderately complex contracts with customers are likely to find that using spreadsheets to manage sales compensation will multiply the workload of the accounting department.
Under ASC 606 and IFRS 15, managing sales compensation in spreadsheets will increase the burden of accounting departments in several respects. Because spreadsheets are error-prone, accountants will need to check all of them to ensure that amounts and calculations are correct. Even assuming that the sales organization will attempt to be diligent in allocating commission and other direct contract acquisition costs appropriately between those that are to be capitalized and those that are to be expensed, accountants will still have to check the work to be certain that no mistakes were made. In the event that changes to a contract affect the commissions paid, ensuring that this information is captured accurately in a spreadsheet and in a fashion that facilitates accounting can be a challenge. Manually posting transaction data taken from a spreadsheet is time-consuming and almost guaranteed to contain errors that will require a reconciliation process to identify. Even if the accounting system has the ability to automate posting transactions using data contained in spreadsheets, checks and reconciliations may be necessary to ensure the process was handled accurately. Moreover, because spreadsheet-based systems are inherently less controlled, they require greater scrutiny by internal and external auditors.
In contrast, sales compensation management software can prevent such issues from occurring. It can simplify tracking of the exact amount of commissions paid on contracts that extend past one year and reliably distinguish between amounts paid to supervisory personnel and commissions paid on contracts with a term of one year or less. The system can be programmed to capture all relevant characteristics of the transaction, automatically calculate commissions and incentive payments, and allocate amounts according to the required accounting treatment. In some companies, complications to accounting for commissions can arise when, say, area managers collect both direct sales commissions (which may be capitalized) and when they receive incentive compensation based on the performance of their direct reports (which must be expensed). Compensation management systems can easily keep these two types of payments separate. Complications can also arise if a contract is extended or modified in a way that will affect the amount and treatment of commission payments. Here also sales compensation management systems can track these changes in a way that facilitates accounting for them. Moreover, having a dedicated system makes it possible to fully automate the posting of all relevant information into the company’s accounting system on whatever schedule, form and format the accounting department prefers. This eliminates the need for manual data entry and ensures accuracy and timeliness.
Facilitating the accounting for capitalized commissions under the new revenue recognition rules is just one reason why we recommend that companies evaluate sales compensation management software. Our research finds that 38 percent of those that use dedicated sales compensation software said they have significantly improved the outcomes of their sales activities and processes. Another 30 percent said they have improved them to some degree. A dedicated application also processes commissions faster and more accurately, which can help retain productive sales people: More than half (57%) of companies said they can handle them in less than a week. Another, more sophisticated benefit is that the sales force is aligned to business strategy and goals, which 43 percent ranked first, more than any other benefit of such software. Other benefits cited are better management and tracking of the progress of product and sales initiatives (by 30%), improved communications to Sales on the status of compensation (26%) and improved auditing and compliance of sales forecasts to goals and targets (25%). Among those planning to adopt dedicated sales compensation management. the highest-ranked expected benefits are to increase revenue and grow the business in terms of net new customers.
We recommend that companies that use spreadsheets to manage sales compensation investigate the benefits of using a dedicated application. The potential impact of the new rules for recognizing revenue from contracts adds another reason why a dedicated application can improve the productivity and performance of both the sales and accounting organizations. As for corporations that already use sales compensation management software and will be affected by the new accounting rules, ensure that the systems are set up to facilitate handling accounting tasks in this new environment.
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