Get Ready to Face a Trifecta of Accounting Standards

The Big 3 Accounting Standards Updates (ASUs) ─ ASU 2014-09, Revenue from Contracts with Customers, ASU 2016-02, Leases, and ASU 2016-13, Financial Instruments – Credit Losses ─  from the Financial Accounting Standards Board pose significant challenges for CPAs. And, as their effective dates loom near, more and more practitioners are coming to realize the substantial level of work involved in applying these standards.

The Center for Plain English Accounting, the AICPA’s national A&A resource center, is receiving and answering quite a few inquiries about how to apply these standards. We recently celebrated our third anniversary of providing our members with valuable guidance on a wide array of accounting, financial reporting, auditing, compilation, review and preparation topics. Recently, we have been especially focused on providing our members with in-depth and practical implementation guidance on the new revenue recognition, leases, and credit loss standards. Below are three implementation questions and answers that we’ve selected to share with you.

1. REVENUE RECOGNITION: How will the new revenue recognition guidance change the percentage-of-completion accounting method used today?

ASU 2014-09 supersedes and replaces the existing percentage-of-completion accounting method, however entities can still recognize revenue over time. Entities will need to establish that their contracts meet certain criteria in order to recognize revenue over the life of the contract.  If an entity qualifies for recognition of revenue over the life of the contract, revenue recognition is likely to be similar to the percentage-of-completion accounting method. Contracts must meet one of three criteria in order to qualify for recognition of revenue over the life of the contract, as follows:

• Customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs their obligations under the contract. An important question to ask related to this is whether another entity would need to substantially re-perform the work the entity has completed to date if that other entity were to fulfill the remaining obligation to the customer.
• Entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced (for example, remodeling a home).
• Entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

Most entities with long-term contracts will be applying the second or third criteria in order to qualify for recognition of revenue over the life of the contract.  Entities who construct an asset on the property of the customer, like a construction contractor, would appear likely to meet the second criterion. However, for those who do not perform on the property of the customer, the third criterion will be significant. This criterion requires that an entity has an enforceable right for performance completed to date. This concept is different than a progress payment since a progress payment may or may not be equal to performance completed to date. Progress payments also could be refundable, depending on the terms of the contract. The enforceability of right for performance completed to date will require a legal determination based on the governing jurisdiction and potentially could require changes to contract language.

2. LEASES: How are related party leases accounted for under the new lease standard?

ASU 2016-02 makes a significant change to the way related party leases are accounted for. Under existing GAAP, related party leases are accounted for based on the substance of the lease. Under the new standard, related party leases will be accounted for on the basis of the legally enforceable terms and conditions of the lease.

Some may conclude that leases between related parties under common control do not have legally enforceable terms and conditions and therefore a de facto scope exception in ASU 2016-02 exists for such leases. The CPEA does not agree with that conclusion. We believe that leases between related parties under common control do get enforced in a variety of settings, such as in divorce proceedings, bankruptcies and in minority shareholder disputes.

The bottom line is that the accounting for related party leases is changing and will present challenges, requiring the exercise of professional judgment in assessing the legally enforceable terms and conditions and the accounting for such leases.

3. CREDIT LOSSES: Does the new current expected credit loss model eliminate individual loan impairment assessments?

Not necessarily. ASU 2016-13 requires an entity to measure expected credit losses of financial assets on a collective (pool) basis when similar risk characteristic(s) exist. The pooling for credit loss measurement should be consistent with the entity’s policies for monitoring credit risk. If part of an entity’s policies for monitoring credit risk is to consider certain creditors individually then an entity would make those individual credit loss assessments under ASU 2016-13.

Practitioners will need help understanding and applying the revenue recognition, leases and credit loss standards. The Center for Plain English Accounting is here to help. We provide our members with written responses to technical inquiries, monthly technical reports, and access to eight two-hour webinars a year. Ensure your firm is ready to handle the Big 3 ASUs by joining the Center for Plain English Accounting.

Bob Durak, Director – Center for Plain English Accounting, American Institute of CPAs.

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