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Newsletter – May 2018

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Is Your Finance Department a Cost or Profit Center?

Allan Tepper, CFO Consulting Partner LLC

To begin, I will define cost and profit centers, using my definition developed after leading accounting and finance functions for over twenty-five years.

Cost centers need to be efficient and be doing critically important tasks. From a company perspective, cost centers need to keep their costs at the lowest possible level while functioning at a highly effective level.

Profit centers have all the same attributes as cost centers, but produce revenue, thereby adding profits to a company’s bottom line.

Well-run finance departments have profit center elements. Although finance departments, as a unit, are not true profit centers because they do not directly produce revenue, they have many positive bottom-line attributes. Finance functions aid other cost and profit centers to be more efficient and effective and incentivize them to work cross-functionally as a team.

There is an often used phrase called a “strategic CFO.” That person would primarily focus on making the whole company stronger. I believe it follows that a goal for all companies should be to make the finance department function more like a profit center than a cost counter.

Examples of how finance departments become strategic include:

– Perfect the closing process so the books are closed quickly and accurately after month end, and time is available for analysis.

– Make the budgeting and reporting process part of a company’s DNA.

– Work with the various company units that feed information to the accounting department in order to make the information accurate and at the proper level of detail.

– Provide analyses that allow for action-oriented decisions. An example would be an analysis of the profitability of various business units. Another could be customer profitability analysis.

– Have the capability – systems and people – to meet the normal demands of all stakeholders on a timely and accurate basis.

– Spearhead merger and acquisition projects.

In summary, well run accounting and finance functions have significant attributes that help improve the bottom line of the whole company. A discussion with a C-level financial management consulting firm should provide insights on how to transform an accounting function from a cost to a “profit center.”

Newsletter – April 2018

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Case Study: Financial Transformation

BACKGROUND

Engaged by a service provider (a boutique law firm) that had been in business for approximately 18 months. Firm was highly successful on the legal side but was immature on the operations/business process side. In 18 months, firm had had three Chief Operating Officers, all from “Big Law” and all who had not been successful. Position had been vacant for three months, placing great stress on the Managing Partner. Total staff the commencement of the engagement was approximately 50, with a ratio of 2 lawyers for each non-legal position.

WHAT WE DID

Our assignment was to perform a high-level assessment of all Firm operations: Finance, HR, IT; Billing and Payables and Administrative support; provide observations and make recommendations for improvement. Assessment also included evaluation of staff morale and related staffing issues. Expected duration of assignment; two weeks.
Assessment identified two issues requiring immediate attention; staff morale and need for full time Chief Operating Officer to relieve burden on Managing Partner. Remedial actions were taken within ten days and included the naming of our consultant as Interim Chief Operating Officer with undefined term of service.

Longer term recommendations included: steps to improve the Firm’s Information Security polices and IT infrastructure, execute a search for and implementation of new ERP system; actions to clarify and realign staff roles, hiring of a full time Finance Director; development of better reporting and creation of a capacity plan; establishment of a more formal HR function.

The firm was in the process of tripling the size of its primary offices as the engagement began. The subsequent six to eight weeks were devoted to managing the myriad of issues associated with that move while stabilizing and improving staff morale. In addition, significant planning was performed on the ERP and IT front while proposing a longer-term staff realignment plan.

Subsequent eight weeks were focused on ERP software selection, full scale IT and information security review, development of a new reporting dashboard for Partners; assessment of firm insurance coverage, development of a new 401K and profit-sharing plan and overseeing year end closing process including management of bonus recommendations.

Post year-end close focus has been on implementation of new ERP system, new 401K and profit sharing plan, complete rebuild of Firm’s IT infrastructure and creation of robust information security practices. In addition, an overall firm capacity plan and forecast was developed.

RESULT

Since our arrival, there has been no staff turnover. Key initiatives have been conceived and executed. Managing Partner is primarily practicing law. Firm is well on the way to having an back office operation that is of the same superior quality as the Firm’s legal practice.

Newsletter – March 2018

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The CECL Approach, 3 of 3

For this newsletter CFO Consulting Partners has partnered with Ardmore Banking Advisors to review the potential material financial benefits of a well planned and executed implementation of the new current expected credit loss (“CECL”) accounting standard.

Most banks have an awareness of the need to prepare for the transition to CECL, and that many foundational activities need to be looked at now. Together CFO Consulting Partners (“CFO CP”) and Ardmore Banking Advisors (“Ardmore”) have constructed an approach to help banks address the “early must do’s” of CECL at a reasonable cost.

CFO CP leverages its extensive experience with banking industry finance, and Ardmore it’s deep expertise in credit and credit data to translate the CECL transition process into tasks and activities that create valuable efficiencies and bottom line impact for the Bank. Together we can cut through the noise and assess a bank’s CECL readiness and at the same time help create a CECL action plan that will drive real value for the bank.

We have discussed aspects of CECL implementations in prior newsletters, The New CECL Approach Part I, and Part II. Similarly, Ardmore’s webinar Step #1 Of the CECL Journey provides additional perspective.

CFO CP and Ardmore are each focused on complementary aspects of the CECL implementation process in the finance, accounting, and credit disciplines. Well executed CECL projects led by an interdisciplinary team of Credit, Finance, and other bank management, coordinated by experienced project managers and executed well, can produce tangible bottom line improvements, and better efficiency ratios.

Experienced CFO CP and Ardmore Project Managers can help the bank’s CECL team identify opportunities for process improvements. The resulting databases, internal control enhancements, and automation will produce faster decisions, easy access to controlled and trusted data, high functioning executive teams and, ultimately, improved efficiency ratios. If CECL implementation is managed well, a bank can leverage the implementation to break down silos, upgrade systems, improve processes, and reduce expenses.

CFOs can strategically manage the spending to required accomplish CECL goals AND drive efficiencies which will ultimately reduce the expense ratio. Opportunities exist in:

  • Credit Administration: Ensure that all credit practices are properly aligned with your CECL implementation, upgrade automation, and improve underwriting processes.
  • Finance: Re-engineer financial controls and loan accounting processes, optimize general ledgers, optimize risk adjusted capital levels, and Improve management information for the Board and Management.
  • IT: Improve data governance, develop and data management tools, and retire inefficient loan and credit systems.
  • Operations: Update credit processes (such as data entry and coding processes), and re-engineer controls and processes
  • Lending: Efficient analysis of deal structures and lending to minimize life of loan losses and capital impacts

An assessment for CECL readiness can reveal a lot that can be useful to the institution beyond the needs of CECL compliance including:

  • Assess the current state of the institution’s credit portfolio data and origination process, ALLL, Financial and
  • Credit policies, practices and governance – all within the context of CECL;
  • Review Current ALLL System & Processes;
  • Review controls on data used in the current ALLL process;
  • Identify data points required to support industry best practice portfolio data & regulatory compliance data for CECL;
  • Review loan origination process, stakeholders, criteria and coding;
  • Review data stored in the core for accuracy consistency and robustness;
  • Review all identified credit data source systems for data/database integrity; and
  • Review any existing data warehouse capabilities, and how portfolio data is organized, maintained, and retained.

CECL compliance practices and implementation plans should be in place in 2018. Auditors, regulators, boards of directors and investors will want to know bank’s plans for CECL, including the costs and the benefits beyond compliance.

Those institutions that leverage the potential benefits of the CECL implementation will have a competitive advantage over their competitors through increased efficiencies, automation and clarification of corporate risk management practices.

About the Authors

CFO Consulting Partners, Tom Van Lenten: Tom leads CFO Consulting Partners CECL consulting services to financial institutions. CFO CP’s CECL services include: CECL readiness assessment, analysis of the accounting and regulatory implications, project management, and assisting with updates of policies, procedures and internal controls which are impacted by CECL.

Ardmore Banking Advisors, Peter Cherpack: EVP, Partner. Peter is a nationally known thought leader in CECL implementation for community banks, and with other Ardmore consultants conducts CECL readiness assessments with a focus on credit and credit data readiness.

Newsletter – February 2018

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A.M. Best Updates Its Rating Methodologies and Capital Model

Marc Liebowitz, CFO Consulting Partner LLC

A.M. Best (AMB) recently revised its rating methodologies, most of the changes relate to updated procedures and the underlying analytical components have generally remained in place. The below videos provide an overview of the methodology updates:
“A.M. Best’s Mosher: Methodology Update, Benchmarks Are Released”
“Market Issues, Methodology Updates Dominate A.M. Best’s NY Briefing”

As part of its revised rating methodology, AMB released its revised capital model, Best Capital Adequacy Ratio (BCAR). While the components and the equations to determine a group’s BCAR ratio have remained largely in place, the revised model applies updated technologies to better determine balance sheet risk. These technologies allow the model to quantify risk across various loss severity scenarios. Below are links that detail the updated processes:
“Understanding BCAR for U.S. Property/Casualty Insurers”
“Understanding BCAR for U.S. and Canadian Life/Health Insurers”

A.M. Best has termed its revised rating procedure the “building block approach.” The first step, or building block, is the capital assessment. Subsequent analytical steps either add or detract from the score assigned during the capital strength assessment. We discussed these steps in our previous articles on the ratings process. See our “Insurance Company Credit Rating Advisory Practice” Part 1 and Part 2

Balance sheet strength remains the foundation of the rating process, Best’s methodology will continue to review current capitalization and forecast future balance sheet strength. Operating performance, business profile and enterprise risk management are key elements which help to determine a groups prospective capital position. View A.M. Best’s Credit Rating Methodology

Benchmarks and peer group analysis remain an important factor in the determination of a group’s rating. Insurance companies which consistently outperform peer and/or industry benchmarks in terms of operating results and business profile are more likely to achieve higher rating categories. Peers are those that generally offer similar products, have approximate premium volume, operate in similar territories or otherwise compete in each other’s respective markets. Given the importance of benchmarks, companies should understand how they are developed and applied over the rating process.

AM Best expects the updates to the capital model and rating processes to support a more detailed rating analysis and lead to greater transparency relative to the assigned rating.

CFO Consulting Partners can guide companies through AMB’s revised rating processes and updated capital model. We can provide an understanding of the drivers of your current rating and develop strategies targeted at achieving your desired rating.

Newsletter – January 2018

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Implementations of the New Lease Standards Under the ASC 842

Mark Sloan, CPA, CFO Consulting Partners

On February 25, 2016, the FASB issued new guidelines under ASC Section 842 regarding the recognition and financial reporting of leases. The new standard will impact both lessees and lessors, with the most significant impact falling upon lessees. The standard is effective for years beginning after December 15, 2018 for public firms and December 15, 2019 for nonpublic firms.

This is one of the most comprehensive changes to accounting principles in many years, almost 250 pages long, and it will require major effort of firms to understand and implement its impact.

Due to the complexity of this pronouncement, this update will focus on the impact the new standard will have on lessees; a future update will focus on the impact on lessors.

In summary, the significant effect of this standard on lessees is as follows:

  1. Transactions which had been previously reflected as rent expense on the income statement will now require a right-of-use asset and a related lease liability being reflected on the balance sheet;
  2. Service arrangements for the use of assets over a period of years need to be evaluated and, if certain criteria is met, there needs to be a segregation of elements that are considered either lease components or non-lease components;
  3. Lease liabilities must be continually evaluated for the occurrence of significant events and revised accordingly, and;
  4. Criteria under previous guidance for determining a lease to be either an operating lease or a financing lease has been changed for the following:
    1. eliminating specific guidance regarding thresholds for determining economic life and fair value of leased assets;
    2. replacing such guidance with transaction specific judgement, and;
    3. adding a criteria that the leased asset has no alternative use to the lessor at the end of the lease term.

As a result of the new standard, it is expected that balance sheets will increase with over $1.5 trillion of additional assets and liabilities.

As a starting point, contracts for services must be reviewed, and both the lease and non-lease components must be identified and segregated. In its simplest terms, the standard states that if a contract conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration, without significant control or substitution rights by the lessor, then a lease exists.

This will be among the most challenging aspect of the new standard. There must also be an analysis to determine whether there are multiple lease components which need to be accounted for separately and whether there are multiple non-lease components which should be accounted for under other appropriate GAAP. Also, there needs to be an ongoing evaluation of contracts to determine when an event occurs that may change the recognition or measurement of the lease, and that the entity distinguish whether there is a modification of an existing lease or the recognition of a new lease arrangement requiring separate accounting.

In addition to arrangements which clearly demonstrate a lessee/lessor relationship (such as the lease of office space), other arrangements must be carefully evaluated to determine if a lease exists. Such arrangements may include:

  • Advertising agreements
  • Service agreements
  • Transportation agreements
  • Construction agreements
  • Related party arrangements

It is important to identify lease and non-lease component of a service arrangement. The arrangement must be carefully evaluated for any asset that could be construed to be a lease in nature. One example is a data storage arrangement with a service provider. If the service contract includes the installation of a server on the location of the lessee, the lessor has no substantive substitution rights and the lessee derives most of the benefit of the asset over the lease term, then the server represents a lease component. An allocation of the rent payments need to be made between the server (the lease component) and the data storage (the non-lease component). The lease component must then be evaluated for either an operating lease or a finance lease and treated accordingly. The major difference between the two types will be that the income statement effect of the operating lease will be through rent expense while the income statement effect of the financing lease will be through interest expense and amortization expense.

Similar to previous guidance, leases meeting certain criteria will be considered a finance lease and there will need to be a right-of-use asset with a corresponding lease liability reflected on the balance sheet. The two amounts will be initially set up as the present value of the lease payments discounted at an appropriate interest rate (e.g., the lessee’s incremental borrowing rate).

A lease meeting any of the five following criteria will need to be classified as a finance lease:

  1. Ownership of the leased asset transfers at the end of the lease term;
  2. A bargain purchase option (i.e., one that is reasonably certain to be exercised) for the leased asset exists;
  3. The lease term, which does not commence near the end of the economic life of the leased asset, is primarily the remaining economic life of the leased asset;
  4. The sum of the present value of the lease payments and the residual value guarantees is equal to, or more than, substantially all of the fair value of the leased asset, and;
  5. The leased asset has no alternative use to the lessor at the end of the lease term because of its specialized nature.

What is important to bear in mind is the new pronouncement removes the 75% (for criteria #3) and 90% (for criteria #4) that former GAAP had provided as guidance and, instead, the lessee will need to take positions as to determining the remaining economic life or substantially all of the fair value of the leased asset. Also new is criteria #5 which needs to be taken into account in the determination of the character of the lease. The right-of-use asset will be amortized on a straight line basis (or any more systemic approach) over the term of the lease and the lease liability will be extinguished using the effective interest method. The income statement will reflect amortization expense for the reduction of the right-of -use asset and interest expense for the interest component of the lease payments.

If a lease arrangement is identified and considered not meeting the above criteria for a finance lease, then such operating lease will reflect, on the balance sheet, a right-of-use asset and a corresponding liability recorded at the present value of the rent payments, using an appropriate interest rate such as the lessee’s incremental borrowing rate. Both the amortization of right-of-use asset and the accreted interest on the lease liability will be reflected in rent expense on the income statement.
If an entity has both finance leases and operating leases, then the right-of-use asset and the lease liabilities must be presented separately for each type of lease.

If there are elements in the lease arrangement for step-up in rent payments, initial direct costs, payments of residual values, etc., such elements must be taken into account in calculating the right-of -use asset and corresponding liability.

Leases with terms of 12 months or less will be exempt from the standard as it relates to reflecting a balance sheet impact. Such leases will continue to be accounted for as under previous guidance, i.e., off balance sheet and footnote disclosure only.

As part of the transition process for the standard, there are practical expedients that an entity may elect, as a package and applied consistently, to all of its leases which commenced prior to the effective date of the standard:

  1. An entity need not reassess whether any expired or existing contracts are or contain leases;
  2. An entity need not reassess the lease classification (i.e., operating versus finance lease) made under previous GAAP for any expired or existing leases, and;
  3. An entity need not reassess initial direct costs for any existing leases.

If an entity foregoes these practical expedients, then it must apply the standard to all previous periods presented for which there are leases or contracts which contain lease and non-lease components.

On January 5, 2018, the FASB issued an Exposure Draft revising some of the provisions of ASC 842. The Board is requesting comments to this Exposure Draft no later than February 5, 2018.

The two issues on which the Board is seeking comments are as follows:

  1. Comparative reporting for initial adoption, and;
  2. Separating and allocating lease and non-lease components in a contract.

As it relates to comparative reporting for initial adoption, the Board has proposed recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. As it relates to separating and allocating lease and non-lease components in a contract, this proposed amendment would be applicable to lessors only. The amendment would provide lessors with a practical expedient that is currently available to lessees, which is to not separate non-lease components from related lease components for identified classes of underlying assets. This practical expedient would be available only upon meeting certain requirements, i.e., (i) the timing and pattern of revenue recognition for the non-lease component(s) and related lease components are the same, and (ii), the combined single lease component would be classified as an operating lease.

A subsequent newsletter will provide an update to the standard once the comment period has expired and the Board has finalized any revisions to ASC 842 regarding the aforementioned issues.

As can be seen from this brief summary, the new pronouncement on lease accounting will have a deep and profound effect on most entities. While the implementation date is still some time off, it would be prudent to begin to assess the effect this pronouncement will have on your financial statements. We here at CFO Consulting Partners have an extensive understanding of the new standard and stand ready to assist in evaluating and implementing this standard.

Newsletter – December 2017

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Physician Practices: The Future is Changing

John DeLorenzo, MBA, CFO Consulting Partners LLC

The United States possibly has the most complex healthcare system in the world. The American healthcare system regulates the industry at both the federal and state level. It is paid for by private health insurance as well as from the government under its Medicare and Medicaid programs. Healthcare services are provided by the private sector; however, the government also provides services directly through the Veterans Administration. All of this, in a population with disparate levels of wealthy and poor citizens, leads to highly chaotic distribution of care and a complex payment system.
While half of all Americans receive healthcare coverage through their employers, most plans are subject to regulations both federally and at the state level. Those Americans receiving healthcare coverage through Medicare and Medicaid, subject the provider to lower reimbursements. As a result, some providers are less willing to take on Medicare and Medicaid patients, leading to a shortage of providers for that patient base. Patients that are not covered by their employer or a federally provided healthcare program are required to seek private insurance. However, because of the Patient Practice and Affordable Care Act (PPACA), patients are generally provided less options then employer plans, and those options may restrict their choices regarding providers.
Because of a more recent development, a totally different method of reimbursement, from fee for service or volume payments, to outcome based reimbursements or Value Based Care (VBC) is being encouraged by both Centers for Medicare and Medicaid (CMS) and by private insurers. Essentially, fees for services under VBC are paid based on case outcome and the payment must be shared by all providers in the continuum. VBC reimbursement was originally introduced by the CMS. Both CMS and now private insurers are moving in the direction of value based reimbursement and providing incentives to providers to participate. What is essential to succeed in the VBC method of reimbursement lie in integration of providers and the ability to aggregate data.
Even prior to the movement to VBC, the PPACA is requiring all practitioners to utilize Electronic Medical Records, (EMR) which is costly in both software acquisition as well as implementation. While a burden to small practitioners and groups, EMR will ultimately allow groups to operate, integrate and bill more efficiently.
As new requirements continue to be heaped on single physician practices and small groups, they have been dwindling as more groups consolidate to gain scale and integration. Also, there is a significant trend toward physician groups selling their practices to hospitals as hospitals are a significant cog in the VBC wheel.
Sole practitioners and practice groups need to assess their situations and determine if they are positioned to continue independently or should they align with a network of providers or sell to a larger group or hospital.
Viability in the changing healthcare delivery model for practice groups will require a significant change in how a practice operates, will require investments in information technology, possibly require upgraded staffing as well as the development of relationships with other providers in the continuum.
CFO Consulting Partners healthcare practice is here to help you. We can assist you to access your current situation and help you create and implement a plan forward. We can also assist you should you decide to align with a network or sell or consolidate with another group or hospital.

 

Newsletter – November 2017

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Are You Ready for the New Revenue Recognition Standard?

Oliver Brooks, CPA, CFO Consulting Partners LLC

INTRODUCTION

On May 14, 2014 the FASB issued the standard ASC 606 Recognition of Revenue from Contracts with Customers. The FASB issued an Accounting Standards update to the Standard (ASU 2016 -10) in April 2016.

The implementation date for the standard is:

  • For public business entities, certain not-for-profit entities, and certain employee benefit plan
    • Reporting periods beginning after Dec 15, 2017
  • For all other entities
    • Reporting periods beginning after December 15, 2018

ASC 606 will have a major impact on the reporting of revenue for all entities, public and private that enter into contracts that promise the exchange of goods and services to their customers with a relatively minor impact on some costs associated with fulfillment of the contracts.

The standard is both complex and far reaching. Consequently, implementation is likely to require considerable effort and expertise.

Entities that plan to report GAAP financials would be well advised to consider moving quickly to initiate a thoughtful plan of action to comply with the standard.

 

OVERVIEW OF THE STANDARD

The following recaps the author’s view of the key guidance in the standard.

Performance obligations

The basic economic transaction is the contract between an entity and its customers. The standard address the accounting for the promises embodied in the contract, which it refers to as performance obligations.

The core principle of the standard is that an entity recognizes revenue when goods and services are delivered or fulfilled.

To achieve the core principle the standard promulgates a series of actions that an entity must undertake are:

  1. Identify the contract with the customer
  2. Identify the distinct performance obligation(s) in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the distinct performance obligations in the contract
  5. Recognize revenue when (or as) the entity satisfies the performance obligation(s)

Disclosures

ASC 606 requires considerably more disclosures about revenue. In general, the intent of the disclosures is to enable the reader to understand the nature and amount of the revenue being recognized and the uncertainty of the related cash flows.  More specifically the entity shall disclose:

  • Contracts
    • Disaggregation of revenue
    • Contract Balances
    • Performance Obligations
    • Transaction price allocated to remaining obligations

Other

The standard provides guidance on several other situations that can arise in the administration of contracts.  For example  (Not a complete recap)

  • Measurement of progress completion
  • Change in estimate
  • Right of return
  • Contract modification
  • Bill and hold arrangements
  • Cash and non cash consideration

 

IMPLEMENTATION

Given the complexity of this standard and its impact on revenue, it is incumbent on entities to have a well thought out implementation and transition plan. Some key issues that the plan should address include:

  • Financial: Determine the revenue streams that are impacted. Assess the need to review all customer contracts, possibly cataloging them and detailing their performance obligations.
    • Review the methodology in place for recognizing revenue and devise an intervention whether interim or final, systematic or manual, that brings revenue recognition into line with the standard
  • If the plan envisions significant manual effort be aware of the increased probability of errors and mitigate it with adequate quality control
  • Information System: Ascertain the need and /or feasibility of reconfiguring the ERP system to seamlessly produce financial information in compliance with the new standard
  • Organization: Communication to internal and external stakeholders. Determine the need for revised guidance to organization units that interface with customers or suppliers with regard to entering into, structuring of and reporting on contracts.
  • Transition: Decide on and prepare for full retrospective or modified retrospective presentation for financial statements presented after the implementation date. I.e.
    • Full retrospective: Apply the new standard as of the implementation date and, for the prior comparative periods, restate all contracts on the same basis
    • Modified retrospective: Apply the new standard as of the implementation date and, for the prior comparative periods, the data is not recast but instead apply a single adjustment to equity at the beginning of the initial year of application.

Companies are advised to begin the process early to ensure compliance. For complex revenue recognition issues, the company may want to consider outside professional resources to assist in the analysis.

More detailed information may be viewed here.

The New Revenue Recognition Standard (ASC 606)

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Introduction

On May 14, 2014 the FASB issued the standard ASC 606 Recognition of Revenue from Contracts with Customers. It is a converged standard with the IASB (IFRS 15) The FASB issued an Accounting Standards update to the Standard (ASU 2016 -10) in April 2016.

The implementation date for the standard is:

  • For public business entities, certain not-for-profit entities, and certain employee benefit plan
    • Reporting periods beginning after Dec 15, 2017
  • For all other entities
    • Reporting periods beginning after December 15, 2018

ASC 606 will have a major impact on the reporting of revenue for all entities, public and private that enter into contracts that promise the exchange of goods and services to their customers with a relatively minor impact on some costs associated with fulfillment of the contracts.

The standard is both complex and far reaching. It impacts not only marketing groups but lilely other groups, for example R&D, that enter into collaborative or other contracts or arrangements with third parties. As a result implantation is likely to require considerable effort and expertise.

Entities that plan to report GAAP financials, both public and private, if they have not already done so, would be well advised to consider moving quickly to initiate a thoughtful plan of action to comply with the standard.

 

Overview of the Standard

The following reviews the authors view of the high points in the standard.

Performance obligations

The basic economic transaction addressed by the standard is the contract between an entity and its customers. The standard address the accounting for the promises embodied in the contract, which it refers to as performance obligations.

The core principle of the standard is that an entity recognizes revenue to depict the transfer of the promised goods or services in amounts and timeframe that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services when (or as) the said goods and services are delivered or fulfilled.

To achieve the core principle the standard promulgates a series of action that an entity must undertake to determine the amount and timing of revenue to be recognized. These are:

  • Identify the contract with the customer
  • Identify the distinct performance obligation(s) in the contract
  • Determine the transaction price
  • Allocate the transaction price to the distinct performance obligations in the contract
  • Recognize revenue when (or as) the entity satisfies the performance obligation(s)

1) Identify the Contract

The contract with the customer is a central aspect of the standard as revenue recognition flows directly from it. Without a contract there can be no revenue recognized under this standard. Evidence that a contract exists is based on:

  • Approval: All parties to the contract have approved the contract (in writing, orally or in accordance with customary business practices)
  • Rights: The contract clearly identifies the rights of the parties
  • Payment: The payment terms are clearly stated
  • The contract has commercial substance (i.e. parties cannot agree to artificially swap goods or services in order to boost revenue)
  • Probability: It is probable that the contract terms will be honored

Note that that new standard by requiring clear identification of the parties’ rights brings a focus on legal enforceability. Therefore, a contract will exist once legal enforceability exists, even if it differs from an entity’s normal and customary business practice.

2) Identify the Distinct Performance Obligations in the Contract

Where a contract recites the transfer of more than a single good or service then the seller must evaluate the goods and services to be transferred as to whether any of them are distinct.

A distinct good or service (or bundle of services) is considered a performance obligation. To be distinct the goods of service must be identified in the contract and be capable of performing a service as delivered or in combination with other services that the customer could readily find.

Note that the drafters and approvers of the contract will, normally be careful to ensure that the contract recites the agreed performance obligations.

This section of the standard generated many comments and questions to the extent that the FASB, in 2016 issued an Accounting Standards Update (ASU) that offered further interpretive guidance (ASU No 2016 -10) April 2016 about Identifying distinct performance obligations and licensing

The ASU provided clarification as follows:

Distinct Goods or Services

A good or service that is promised to a customer is distinct if both the following criteria are met:

  1. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is the good or service is capable of being distinct)
  2. The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract

The ASU provided further guidance as follows:

In assessing whether an entity’s promise to deliver separately identifiable services to a customer are distinct the objective is to determine whether the nature of the promise, within the context of the contract is to transfer each of those goods or services individually, or instead, to transfer a combined item or items to which the promised goods or services are inputs.

The ASU goes on to cite factors that merit consideration in making the determination. One such factor cited is the instance where   “ The goods or services are highly interdependent or interrelated, In some cases two or more good or services are significantly affected by each other because the entity could not be able to fulfill its promise by transferring each of the good or services independently.”

The above situation would seem to be evidence that the goods or services merit treatment as a combined item

Immaterial items

  • An entity is not required to assess whether goods or services are performance obligations if they are immaterial to the contract

Administrative activities

  • Promised goods or services do not include the various administrative activities the vendor must perform to setup a contract as those tasks do not transfer services to the customer

Shipping and handling

  • An entity that promises a good to a customer might perform shipping and handling related to the good. If the shipping and handling occur before the customer has control of the good then the shipping and handling is not a performance obligation but rather an activity to fulfill the entity’s promise to transfer the good
    • However if the shipping and handling activities occur after the customer has obtained control of the good the entity is permitted as an accounting policy election to account for them as an activity to effect transfer of the goods rather than as an additional promised service

Combining contracts

An entity may combine one or more contacts entered into at or about the same time with the same customer and account for them as a single contract if one or more of the following criteria are satisfied:

  • The contracts are negotiated as a package with a single commercial objective
  • The goods and services promised in the contracts constitute a single performance obligation
  • The consideration paid in one contract is dependent on the price or performance of the other contract

3) Determine the transaction price

Determining the transaction price as of the inception of the contract may not be straightforward. The price may be subject to discounts, rebates, penalties and/or performance bonuses, which cannot be precisely quantified at the contract inception. However, even if not straightforward it is incumbent on the entity to estimate the price. The standard present certain approaches:

  • Most likely price. The seller develops a range of possible prices and selects the most likely
  • Expected value of the price. The seller develops a range of possible prices, assigns a probability to each and derives the expected value

Whichever method is chosen the seller should apply it consistently throughout the contract and for similar contracts.

Note also that the standard addresses other matters that could complicate price determination such as:

  • Payments over a period of time – price is deemed to include a financing component which must be accounted for separately
  • Non cash consideration – fair value of the consideration must be determined
  • Payments in advance – are not revenue but a liability

4) Allocate the transaction price to the performance obligations

In this step the entity determines the stand-alone selling price of each performance obligation as of the inception of the contract. The best evidence of that price would be an observable price of the good or service when the seller sells it to a similar customer under similar circumstances.

If it is not possible to observe a stand-alone price the entity must estimate it. The following represents possible acceptable ways to estimate a stand-alone selling price:

  • Adjusted market assessment: Reviewing the market for like products and their pricing
  • Cost plus margin: the seller estimates their cost and adds an appropriate margin
  • Residual approach: subtract the determined standalone price(s) from the contract price and apply that difference to the other obligations. This approach can be difficult to use.

Once the seller derives an approach for estimating stand-alone selling prices it should apply that approach consistently for other goods or services with similar characteristics.

Discounts

It can turn out that the sum of the estimated standalone prices exceeds the contract price in which case the customer is deemed to have received a discount. The discount should be allocated across the performance obligations in proportion to their standalone price except there is evidence that the discount should be applied to one or more specific obligations

5) Recognize revenue when (or as) the entity satisfies the performance obligation

Revenue is to be recognized when (or as) goods or services are transferred to the customer. The transfer is considered to have occurred when the customer has gained control over the good or service, that is, when the customer has taken on the significant risks and rewards of ownership, for example, the seller can sell, pledge or exchange the asset.

It is possible that a performance obligation will be transferred over time rather than at a point in time.  Service contracts or construction contracts are example of performance obligations transferred over time. The seller’s entitlement to payment will be controlled by the contract terms, for example, when milestones are reached and/or when the customer is satisfied with a deliverable or other criteria specified in the contract.

 

Costs incurred to obtain a contract.

An organization may incur costs to obtain a contract. If so, it is allowable to capitalize these costs and amortize then over the life of the contract provided:

  • The costs are incremental: An example would be sales commissions
  • There is an expectation that the costs will be recovered
  • Note that if the amortization period will be one year or less it is allowable to expense these costs as incurred

An entity may incur costs to fulfill a future performance obligation. In general such costs should be recognized as assets if they meet the following criteria:

  • The costs are tied to a specific contract
  • The costs are incurred to satisfy a future performance obligation
  • There is an expectation that the costs will be recovered

Warranties

A warranty is a guarantee related to the performance of a delivered goods or service. In general there are two types of warranty:

  • The seller warrants the goods or service at no cost to the customer. The seller accounts for the warranty cost by establishing a reserve based on prior experience and adjusts it over time to reflect more current experience
  • The seller offers the option to the seller of separately purchasing a warranty. As such the warranty is considered a separate performance obligation

Licensing

An entity may offer a customer a license to use intellectual property owned by the seller. If a contract contains both a licensing agreement and a provision to provide goods and services the seller must identify each performance obligation in the contract and allocate the transaction price.

ASU No 2016 -10   April 2016 Identifying Performance Obligations and Licensing) provided updated guidance on accounting for licenses. That is:

  • On whether an entity’s promise to grant a license provides the customer with a right to use the entity’s intellectual property (which is satisfied at a point in time) OR to access the intellectual property (which is satisfied over time)
  • On the recognition of revenue for a usage or sales based royalty in exchange for a license of intellectual property. Essentially the ASU disallows the splitting of the royalty into a portion based on sales or usage and a portion that is not subject to that guidance

Disclosures

ASC 606 requires considerably more disclosures about revenue. In general, the intent of the disclosures is to enable the reader to understand the nature and amount of the revenue being recognized and the uncertainty of the related cash flows.  More specifically the entity shall disclose:

  • Contracts
    • Disaggregation of revenue
    • Contract Balances
    • Performance Obligations
    • Transaction price allocated to remaining obligations
  • Significant judgments made in the application of the standard
  • Practical Expedients relied upon e.g.
    • Existence of a financing component in the contract
    • Incremental costs of obtaining a contract

Other

The standard provides guidance on several other situations that can arise in the administration of contracts.  For example  (Not a complete recap:)

  • Measurement of progress completion
  • Change in estimate
  • Right of return
  • Contract modification
  • Bill and hold arrangements
  • Cash and non cash consideration

 

Implementation

Given the complexity of this standard and its impact on revenue, a most critical financial metric it is incumbent on entities to have a well thought out implementation and transition plan. Some key issues that the plan should address include:

  • Financial: Determine the revenue streams that are impacted. Assess the need to review all customer contracts, possibly cataloging them and detailing their performance obligations.
    • Review the methodology in place for recognizing revenue and devise an intervention whether interim or final, systematic or manual, that brings revenue recognition into line with the standard
    • If the plan includes significant manual effort be aware of the increased probability of errors and mitigate it with adequate quality controls
  • Information System: Ascertain the need and /or feasibility of reconfiguring the ERP system to seamlessly produce financial information in compliance with the new standard
  • Organization: Communication to internal and external stakeholders. Determine the need for revised guidance to organization units that interface with customers or suppliers with regard to entering into structuring of and reporting on contracts.
  • Transition: Decide on and prepare for full retrospective or modified retrospective presentation for financial statements presented after the implementation date. I.e.
    • Full retrospective: Apply the new standard as of the implementation date and, for the prior comparative periods, restate all contracts on the same basis
    • Modified retrospective: Apply the new standard as of the implementation date and, for the prior comparative periods, the data is not recast but instead apply a single adjustment to equity at the beginning of the initial year of application.

The CECL Approach, 3 of 3

By

For this newsletter CFO Consulting Partners has partnered with Ardmore Banking Advisors to review the potential material financial benefits of a well planned and executed implementation of the new current expected credit loss (“CECL”) accounting standard.

Most banks have an awareness of the need to prepare for the transition to CECL, and that many foundational activities need to be looked at now. Together CFO Consulting Partners (“CFO CP”) and Ardmore Banking Advisors (“Ardmore”) have constructed an approach to help banks address the “early must do’s” of CECL at a reasonable cost.

CFO CP leverages its extensive experience with banking industry finance, and Ardmore it’s deep expertise in credit and credit data to translate the CECL transition process into tasks and activities that create valuable efficiencies and bottom line impact for the Bank. Together we can cut through the noise and assess a bank’s CECL readiness and at the same time help create a CECL action plan that will drive real value for the bank.

We have discussed aspects of CECL implementations in prior newsletters, The New CECL Approach Part I, and Part II. Similarly, Ardmore’s webinar Step #1 Of the CECL Journey provides additional perspective.

CFO CP and Ardmore are each focused on complementary aspects of the CECL implementation process in the finance, accounting, and credit disciplines. Well executed CECL projects led by an interdisciplinary team of Credit, Finance, and other bank management, coordinated by experienced project managers and executed well, can produce tangible bottom line improvements, and better efficiency ratios.

Experienced CFO CP and Ardmore Project Managers can help the bank’s CECL team identify opportunities for process improvements. The resulting databases, internal control enhancements, and automation will produce faster decisions, easy access to controlled and trusted data, high functioning executive teams and, ultimately, improved efficiency ratios. If CECL implementation is managed well, a bank can leverage the implementation to break down silos, upgrade systems, improve processes, and reduce expenses.

CFOs can strategically manage the spending to required accomplish CECL goals AND drive efficiencies which will ultimately reduce the expense ratio. Opportunities exist in:

  • Credit Administration: Ensure that all credit practices are properly aligned with your CECL implementation, upgrade automation, and improve underwriting processes.
  • Finance: Re-engineer financial controls and loan accounting processes, optimize general ledgers, optimize risk adjusted capital levels, and Improve management information for the Board and Management.
  • IT: Improve data governance, develop and data management tools, and retire inefficient loan and credit systems.
  • Operations: Update credit processes (such as data entry and coding processes), and re-engineer controls and processes
  • Lending: Efficient analysis of deal structures and lending to minimize life of loan losses and capital impacts

An assessment for CECL readiness can reveal a lot that can be useful to the institution beyond the needs of CECL compliance including:

  • Assess the current state of the institution’s credit portfolio data and origination process, ALLL, Financial and Credit policies, practices and governance – all within the context of CECL;
  • Review Current ALLL System & Processes;
  • Review controls on data used in the current ALLL process;
  • Identify data points required to support industry best practice portfolio data & regulatory compliance data for CECL;
  • Review loan origination process, stakeholders, criteria and coding;
  • Review data stored in the core for accuracy consistency and robustness;
  • Review all identified credit data source systems for data/database integrity; and
  • Review any existing data warehouse capabilities, and how portfolio data is organized, maintained, and retained.

CECL compliance practices and implementation plans should be in place in 2018. Auditors, regulators, boards of directors and investors will want to know bank’s plans for CECL, including the costs and the benefits beyond compliance.

Those institutions that leverage the potential benefits of the CECL implementation will have a competitive advantage over their competitors through increased efficiencies, automation and clarification of corporate risk management practices.

About the Authors

CFO Consulting Partners, Tom Van Lenten: Tom leads CFO Consulting Partners CECL consulting services to financial institutions. CFO CP’s CECL services include: CECL readiness assessment, analysis of the accounting and regulatory implications, project management, and assisting with updates of policies, procedures and internal controls which are impacted by CECL.

Ardmore Banking Advisors, Peter Cherpack: EVP, Partner. Peter is a nationally known thought leader in CECL implementation for community banks, and with other Ardmore consultants conducts CECL readiness assessments with a focus on credit and credit data readiness.

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