Early Revenue Recognition Adopters Provide Some Guidance on MD&A Disclosures
I recently wrote a blog on considerations for MD&A disclosures on adoption of the new revenue recognition standard. After learning a few Form 10-Qs had been filed by early adopters, I took a look to see if they lined up with my thinking. All of the filings taken together supported my ideas in one way or another, but perhaps none implemented everything I wrote about, perhaps because of materiality.
It is also interesting to compare the early adopters predictions as to the impact of the adoption in their most recently filed Form 10-K prior to adoption to the actual impact disclosed in the first Form 10-Q after adoption.
Ford used the modified retrospective method to transition to the new standard. In Footnote 1 to the financial statements, it discloses:
- We expect the impact of the adoption of the new standard to be immaterial to our net income on an ongoing basis.
- A majority of our sales revenue continues to be recognized when products are shipped from our manufacturing facilities. Under the new revenue standard, certain vehicle sales where revenue was previously deferred, such as vehicles subject to a guaranteed resale value recognized as a lease and transactions in which a Ford-owned entity delivered vehicles, we now recognize revenue when vehicles are shipped.
- The new revenue standard also provided additional clarity that resulted in reclassifications to or from Revenue, Cost of sales, and Financial Services other income/(loss), net.
Footnote 2 discloses automotive revenue increased $333 million to $36,475 million in the first quarter as a result of the new standard, and net income increased $27 million to $1,594 million as a result of adoption.
There are no prominent disclosures in the MD&A regarding adoption of the new standard, which is likely the result of Ford’s view on materiality, or viewing MD&A discussion as being redundant to the financial statement disclosures.
In Item 4 under the caption “Controls and Procedures”, Ford discloses:
Beginning January 1, 2017, we implemented ASC 606, Revenue from Contracts with Customers. Although the new revenue standard is expected to have an immaterial impact on our ongoing net income, we did implement changes to our processes related to revenue recognition and the control activities within them. These included the development of new policies based on the five-step model provided in the new revenue standard, new training, ongoing contract review requirements, and gathering of information provided for disclosures.
I believe Ford was the only early adopter to address the foregoing point.
Footnote 3 to the Financial Statements in Ford’s 2016 10-K disclosed:
We will adopt the new revenue guidance effective January 1, 2017, by recognizing the cumulative effect of initially applying the new standard as an increase to the opening balance of retained earnings. We expect this adjustment to be less than $100 million, with an immaterial impact to our net income on an ongoing basis. Adoption of the new standard will also result in changes in classification between Revenues, Cost of sales, Non-Financial Services interest income and other income/(loss), net, and Financial Services other income/(loss), net.
It appears the actual adjustment in the first quarter was to increase opening retained earnings by $36 million.
General Dynamics adopted the new revenue recognition standard “using the retrospective transition method”, but since they restated the first quarter of 2016 I assume they meant what many describe as the “full retrospective method.” The MD&A discloses:
- In the Aerospace group, we record revenue on contracts for new aircraft when control is transferred to the customer, generally when the customer accepts the fully outfitted aircraft. Revenue associated with the group’s completions of other original equipment manufacturers’ (OEMs) aircraft and the group’s services businesses are recognized as work progresses or upon delivery of services. Fluctuations in revenue from period to period result from the number and mix of new aircraft deliveries, progress on aircraft completions and the level of aircraft service activity during the period.
- In the three defense groups, revenue on long-term government contracts is recognized generally over time as the work progresses, either as the products are produced or as services are rendered. Typically, revenue is recognized over time using an input measure (e.g., costs incurred to date relative to total estimated costs at completion) to measure progress. Operating costs for the defense groups consist of labor, material, subcontractor, overhead and G&A costs and are recognized generally as incurred. Variances in costs recognized from period to period reflect primarily increases and decreases in production or activity levels on individual contracts. Because costs are used as a measure of progress, year-over-year variances in cost result in corresponding variances in revenue, which we generally refer to as volume.
In the critical accounting policy section of the MD&A, General Dynamics discloses:
Accounting for long-term contracts and programs involves the use of various techniques to estimate total contract revenue and costs. Contract estimates are based on various assumptions to project the outcome of future events that often span several years. We review and update our contract-related estimates regularly. We recognize adjustments in estimated profit on contracts under the cumulative catch-up method. Under this method, the impact of the adjustment on profit recorded to date is recognized in the period the adjustment is identified. The aggregate impact of adjustments in contract estimates increased our operating earnings (and diluted earnings per share) by $50 ($0.11) and $58 ($0.12) for the three-month periods ended April 2, 2017, and April 3, 2016, respectively. No adjustment on any one contract was material to our unaudited Consolidated Financial Statements for the three-month periods ended April 2, 2017, and April 3, 2016.
Note Q to the financial statement discloses the quantitative effect of restating the first quarter of 2017 to comply with the new standard. Qualitatively, the note discloses:
The adoption of ASC Topic 606 had two primary impacts on our Consolidated Financial Statements. The impact of adjustments on profit recorded to date is now recognized in the period identified (cumulative catch-up method), rather than prospectively over the remaining contract term. For our contracts for the manufacture of business-jet aircraft, we now recognize revenue at a single point in time when control is transferred to the customer, generally when the customer accepts the fully outfitted aircraft. Prior to the adoption of ASC Topic 606, we recognized revenue for these contracts at two contractual milestones: when green aircraft were completed and accepted by the customer and when the customer accepted final delivery of the fully outfitted aircraft. The cumulative effect of the adoption was recognized as a decrease to retained earnings of $372 on January 1, 2015.
Note B to the financial statements has a detailed discussion on performance obligations and use of estimates, including variable consideration.
The MD&A included in the Form 10-K for 2016 includes a discussion of the Company’s implementation plan and the expected effect of the adoption of the new standard. The MD&A in the 10-K also:
- Notes that the outlook for 2017 has been developed under Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers.
- Includes a table showing restated results for 2015 and 2016 under the new standard.
- Includes a useful cautionary note which says “The impact of ASC Topic 606 on our 2015 and 2016 operating results may or may not be representative of the impact on subsequent years’ results.”
Raytheon is another contract intensive company that adopted the new standard using the full retrospective method. The introduction to the MD&A includes a comprehensive update to the Critical Accounting Estimates section of the 10-K. Select disclosures include:
- To determine the proper revenue recognition method for contracts for complex aerospace or defense equipment or related services, we evaluate whether two or more contracts should be combined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performance obligation. This evaluation requires significant judgment and the decision to combine a group of contracts or separate the combined or single contract into multiple performance obligations could change the amount of revenue and profit recorded in a given period.
- We generally recognize revenue over time as we perform because of continuous transfer of control to the customer. For U.S. government contracts, this continuous transfer of control to the customer is supported by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay us for costs incurred plus a reasonable profit and take control of any work in process. Similarly, for non-U.S. government contracts, the customer typically controls the work in process as evidenced either by contractual termination clauses or by our rights to payment for work performed to date plus a reasonable profit to deliver products or services that do not have an alternative use to the Company.
- Due to the nature of the work required to be performed on many of our performance obligations, the estimation of total revenue and cost at completion (the process described below in more detail) is complex, subject to many variables and requires significant judgment. It is common for our long-term contracts to contain award fees, incentive fees, or other provisions that can either increase or decrease the transaction price. These variable amounts generally are awarded upon achievement of certain performance metrics, program milestones or cost targets and can be based upon customer discretion. We estimate variable consideration at the most likely amount to which we expect to be entitled.
Raytheon appears to go a mile more than what is required in the quarter of adoption. Rather than disclosing the effect of adoptions for the first quarter of 2016, it shows the effect for all three quarters in 2015 and 2016.
In its Form 10-K for 2016, Raytheon is ahead of the game again where it notes the unaudited effect of the adoption of the new standard in 2016 and 2015 on select income statement line items and per share amounts. Raytheon also notes:
The impact of adopting the new standard on our 2015 and 2016 total net sales and operating income is not material. The immaterial impact of adopting Topic 606 primarily relates to the deferral of commissions on our commercial software arrangements, which previously were expensed as incurred but under the new standard will generally be capitalized and amortized over the period of contract performance or a longer period if renewals are expected and the renewal commission is not commensurate with the initial commission, and policy changes related to the recognition of revenue and costs on our defense and commercial software contracts to better align our policies with the new standard, which may impact the timing of revenue. The impact to our results is not material because the analysis of our contracts under the new revenue recognition standard supports the recognition of revenue over time under the cost-to-cost method for the majority of our contracts, which is consistent with our current revenue recognition model. Revenue on the majority of our contracts will continue to be recognized over time because of the continuous transfer of control to the customer.
Hat tip to PLI’s The SEC Institute Blog for pointing out these filings.
Contact Steve Quinlivan for more information.