When it comes to recognizing revenues and expenses, U.S. Generally Accepted Accounting Principles (GAAP) don’t leave companies much leeway. With rules regarding cutoff periods changing for some companies as they begin to adopt the new revenue recognition standard, there are some important facts to be aware of.
How closely does your company follow the cutoff rules? The end of the period serves as a “cutoff” for recognizing revenue and expenses. However, some companies may be tempted to play timing games to lower taxes or boost financial results.
To illustrate, let’s suppose a calendar-year, accrual-basis car dealer allows a customer to take home a minivan for a weekend test drive on December 29, 2017. The sales manager has verbally negotiated a deal with the customer, but the customer still needs to crunch the numbers with his spouse. The customer plans to return on January 2 to close the deal — or return the vehicle. Should the sale be reported in 2017 or 2018?
Alternatively, consider a calendar-year, accrual-basis retailer that pays January’s rent on December 29, 2017. Rent is due on the first day of the month. Can the store deduct the extra month’s rent from this year’s taxable income?
As tempting as it might be to inflate revenue to impress stakeholders or defer profits to lower your tax bill, the cutoff for a calendar-year business is December 31. So in both examples, the transaction should be reported in 2018.
The rules regarding cutoffs are changing for some companies. Under Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, revenue should be recognized “to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the goods or services.” In some cases, the new standard could cause revenue to be reported sooner or later than under the existing rules. The updated standard goes into effect in 2018 for public companies and 2019 for private companies.
The new guidance requires management to make judgment calls about identifying performance obligations (promises) in contracts, allocating transaction prices to these promises and estimating variable consideration. These judgments could be susceptible to management bias or manipulation.
In turn, the risk of misstatement and the need for expanded disclosures will bring increased attention to revenue recognition practices. So, expect your auditors to ask more questions about cutoff policies and to perform additional audit procedures to test compliance with GAAP. For instance, they’ll likely review a larger sample of customer contracts and invoices to ensure you’re accurately applying the cutoff rules.
Timing is a critical component of financial reporting. As rules begin to change, it’s vital to understand your company’s requirements so that you can comply with the rules and minimize the chance of an audit adjustment next season. If you have questions about the rules regarding when to record revenue or expenses or need other financial reporting assistance, JLK Rosenberger can help. For more information, call us at (818) 334-8623 or click here to contact us.