Senior Manager, Durkin Group
However, what they may not have realized is that this new directive can have an unintended impact on lender risk, especially in asset-based lending arrangements in which accounts receivable are included as a significant component of borrowing base reporting.
Five Tier Approach
Despite the guidance’s title, Contracts with Customers, this advice is applicable for the large majority of day-to-day borrower transactions within any given industry and is not limited to industries where receivables would be initiated by formal contractual agreements (e.g. nearly all shipment of product or provision of services is covered by this standard). The new guidance, which was issued as FASB Accounting Standard Codification 606 (ASC 606)2, creates a five-tiered approach to recognizing revenue, which is applicable to transactions in nearly all industries:
Step 1: Identify the contract with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
Step 2 and Step 5 are the focus of this article as management’s judgement in determining performance obligations and the subsequent determination of the point at which each performance obligation is satisfied can create additional lender risk (versus use of prior regulations). A performance obligation can be generally defined as a requirement to transfer either a good or service. However, defining the point at which this obligation has been satisfied requires significant judgement on the part of management. While consistent application is required in both new and old revenue directives, new guidance appears to allow management more flexibility in the ways they first establish and define both a “performance obligation” and “satisfaction” of this obligation, which can in turn impact when accounts receivable are booked and included in collateral reporting.
Let’s first look at revenue recognition criteria in place prior to the implementation of ASC 606. Although technically geared for publicly traded companies, most public and privately held borrowers followed SEC Staff Accounting Bulletin Topic 13 (SAB Topic 13) guidance in which borrowers would generally recognize revenue when it was realized or realizable and earned, which was at the point that all of the following criteria were met3:
• Persuasive evidence of an arrangement existed
• Delivery had occurred or services had been rendered
• The seller’s price to the buyer was fixed or determinable
• Collectibility was reasonably assured
In fact, it was not unusual for audited financial statements to list all, or a portion of, the four SAB Topic 13 components within a borrower’s description of revenue recognition practices. Although companies may still consider SAB Topic 13 criteria in their internal determination of when to recognize revenue, ASC 606 appears to grant management more leeway in defining each performance obligation, as well as satisfaction of a performance obligation within the confines of recognizing revenue in a clear, consistent and systematic way moving forward.
When free-on-board (FOB) shipment or FOB destination terms are clearly outlined in a product invoice to a customer, and these terms are consistent with language in a customer-generated purchase order, revenue recognition should remain fairly straightforward, with revenue recognized at the point of carrier pick-up from the borrower’s dock (FOB shipping point) or at the point of carrier delivery to the customer’s dock (FOB destination). However, the following example illustrates how management could take a more aggressive approach in defining satisfaction of performance obligations while interpreting and defining revenue recognition criteria within the confines of ASC 606.
Use of Ex Works Incoterms
Ex works (EXW) is defined by the International Chamber of Commerce to indicate that the seller delivers when it places the goods at the disposal of the buyer at the seller’s premises or at another place. The seller does not need to load the goods on any collecting vehicle, nor does it need to clear the goods for export, where such clearance is applicable4. While Incoterms, such as EXW, can be useful in allocating transportation costs, insurable risk of loss, etc. it does not, and is not intended to, convey the point of legal title transfer, which can lead to a gray area when management relies on Incoterms for revenue recognition purposes. Criteria released to date under ASC 606 for bill-and-hold transactions (transactions permitting the recognition of revenue prior to shipment) lists several criteria, one of which requires that the customer must have obtained control of the product. This transfer of control contrasts to pre-ASC 606 requirements that required that risks of ownership must have passed to the buyer, with “risks of ownership” generally having been interpreted to include legal title transfer as well as risk of loss of the product.
The replacement of “risks of ownership” with “control” leaves an avenue open for revised management interpretation in situations such as the use of the EXW Incoterms as a basis for revenue recognition (e.g. under new guidance, as long as management is able to rationalize that control has passed, this revenue may be able to be recognized once product is staged for pick-up).
Let’s assume that Delphos Distributing has issued a purchase order to Paris Company for 200 widgets at $3,000 each, including an indication of EXW Wichita, KS (the seller’s plant) as Delphos Distributing intends to arrange carrier accommodations to pick up the product at Paris Company’s manufacturing facility at a future (undefined) date. Standard invoices issued by Paris Company are silent on FOB terms, but rather only list Incoterms of EXW Wichita, KS (consistent with the customer purchase order verbiage). Therefore, the anticipated timeline components of the transaction is as shown in the exhibit above.
It is a straightforward conclusion Paris Company’s agreement to manufacture and make available for pick-up the 200 widgets is the performance obligation in this example. At which point, however, has this performance obligation been satisfied? Should it be at the point these items are staged for pick-up in line with the EXW terms regarding party obligations throughout the transportation process? Or should it be at the point of actual pick-up by the customer-coordinated freight carrier (more in line with physical, and likely legal title, transfer)? Where prior revenue guidance may have leaned toward the second option, to ensure that legal title had transferred to Delphos Distributing, management might decide to utilize the updated revenue guidance to establish the point of performance obligation satisfaction using the first option to link Incoterms responsibility tiers with revenue recognition control transfer definitions. Should this shift occur, a lender would want to be diligent in ensuring no change in current lending requirements (e.g. obtaining bill and hold letters if revenue is recognized prior to shipment) despite a shift in accounting definitions.
Understanding Changes to Borrower Revenue Policies
Most industries will likely see minimal change to revenue recognition policies as a result of ASC 606 implementation. It would be a prudent step, however, for lenders to fully understand changes to borrower revenue recognition policies. For a borrower with tight liquidity, even a slight acceleration in the entrance of receivables into the borrowing base can be the difference between showing an overadvance and showing much needed availability, albeit additional masked risk for the lender. While a simple topical discussion with management may create a bridge to understanding year-over-year differences in recognition policies, a lender could also utilize other steps in order to gain comfort that policies remain unchanged with the adoption of ASC 606. Among other things, steps could include comparing revenue recognition definitions within audited financial statements in the current year to those in the prior year, as well as analyzing changes in deferred revenue (contra-asset or liability) balance sheet accounts before and after the adoption of new revenue recognition guidance.
As with any regulation transition, the opportunity exists for management to reset its criteria in defining accounting treatment of certain transactions. Timing of recognition of revenue, for example. Although more clarification on certain revenue recognition sub-topics, such as transactions permitting revenue recognition prior to shipment, is likely forthcoming as governing bodies attempt to streamline more common gray areas of revenue recognition, lenders should take the necessary steps to ensure that additional risk has not been assumed under existing credit arrangements as a result of a borrower’s transition to ASC 606 compliance. •