Cash flow management 101: Basic steps for small businesses

Executive compensation, bonuses, and other cost structure items, such as rent, are often contentious issues in business valuations, as business valuations are often valued by reference to the income they produce. If the business being valued pays its employees an above-market rate, for example, its income will be depressed. Accordingly, if no adjustments are made, the value of the business will also be diminished.

When valuing controlling ownership interests, valuation analysts often restate above- or below-market items (compensation, bonuses, rent, etc.) to a fair market level to reflect what a hypothetical buyer would pay. In the valuation of companies with ESOPs, the issue gets more complicated. The following hypothetical example illustrates why.

Glamorous Grocery is a company that is 100% owned by an ESOP. A valuation analyst is retained to estimate the fair market value of each ESOP share. Glamorous Grocery generates very little income, in part because several executives are overcompensated. The valuation analyst normalizes executive compensation to a market level. This increases Glamorous Grocery’s income, and by extension the fair market value of Glamorous Grocery, ultimately resulting in a higher ESOP share value.

Glamorous Grocery’s trustee then uses this valuation to establish the market price of ESOP shares for the following year. When employees retire, Glamorous Grocery buys employees out at the established share price. The problem? As mentioned before, Glamorous Grocery generates very little income and as a result has difficulty obtaining the liquidity to buy out employees.

This simple example illustrates the concerns about normalizing executive compensation in ESOP valuations. If you reduce executive compensation for valuation purposes, the share price increases, putting a heavier burden on the company when you redeem shares. The company, which already has reduced income from paying above-market executive compensation, may struggle to redeem shares at the established price.

While control-level adjustments may be common, it is worth considering whether they are appropriate in an ESOP valuation. It is important that the benefit stream reflect the underlying economic reality of the company to ensure longevity of the company and the company’s ESOP.

Questions? Our valuation team will be happy to help. 

BerryDunn’s Business Valuation Group partners with clients to bring clarity to the complexities of business valuation, while adhering to strict development and reporting standards. We render an independent, objective opinion of your company’s value in a reporting format tailored to meet your needs. We thoroughly analyze the financial and operational performance of your company to understand the story behind the numbers. We assess current and forecasted market conditions as they impact present and future cash flows, which in turn drives value.

Do you know what would happen to your company if your CEO suddenly had to resign immediately for personal reasons? Or got seriously ill? Or worse, died? These scenarios, while rare, do happen, and many companies are not prepared. In fact, 45% of US companies do not have a contingency plan for CEO succession, according to a 2020 Harvard Business Review study.  

Do you have a plan for CEO succession? As a business owner, you may have an exit strategy in place for your company, but do you have a plan to bridge the leadership gap for you and each member of your leadership team? Does the plan include the kind of crises listed above? What would you do if your next-in-line left suddenly? 

Whether yours is a family-owned business, a company of equity partners, or a private company with a governing body, here are things to consider when you’re faced with a situation where your CEO has abruptly departed or has decided to step down.  

1. Get a plan in place. First, assess the situation and figure out your priorities. If there is already a plan for these types of circumstances, evaluate how much of it is applicable to this particular circumstance. For example, if the plan is for the stepping down or announced retirement of your CEO, but some other catastrophic event occurs, you may need to adjust key components and focus on immediate messaging rather than future positioning. If there is no plan, assign a small team to create one immediately. 

Make sure management, team leaders, and employees are aware and informed of your progress; this will help keep you organized and streamline communications. Management needs to take the lead and select a point person to document the process. Management also needs to take the lead in demeanor. Model your actions so employees can see the situation is being handled with care. Once a strategy is identified based on your priorities, draft a plan that includes what happens now, in the immediate future, and beyond. Include timetables so people know when decisions will be made.  

2. Communicate clearly, and often. In times of uncertainty, your employees will need as much specific information as you can give them. Knowing when they will hear from you, even if it is “we have nothing new to report” builds trust and keeps them vested and involved. By letting them know what your plan is, when they’ll receive another update, what to tell clients, and even what specifics you can give them (e.g., who will take over which CEO responsibility and for how long), you make them feel that they are important stakeholders, and not just bystanders. Stakeholders are more likely to be strong supporters during and after any transition that needs to take place. 

3. Pull in professional help. Depending on your resources, we recommend bringing in a professional to help you handle the situation at hand. At the very least, call in an objective opinion. You’ll need someone who can help you make decisions when emotions are running high. Bringing someone on board that can help you decipher what you have to work with and what your legal and other obligations may be, help rally your team, deal with the media, and manage emotions can be invaluable during a challenging time. Even if it’s temporary. 

4. Develop a timeline. Figure out how much time you have for the transition. For example, if your CEO is ill and will be stepping down in six months, you have time to update any existing exit strategy or succession plan you have in place. Things to include in the timeline: 

• Who is taking over what responsibilities? 
• How and what will be communicated to your company and stakeholders? 
• How and what will be communicated to the market? 
• How will you bring in the CEO's replacement, while helping the current CEO transition out of the organization? 

If you are in a crisis situation (e.g., your CEO has been suddenly forced out or asked to leave without a public explanation), you won’t have the luxury of time.  

Find out what other arrangements have been made in the past and update them as needed. Work with your PR firm to help with your change management and do the right things for all involved to salvage the company’s reputation. When handled correctly, crises don’t have to have a lasting negative impact on your business.   

5. Manage change effectively. When you’re under the gun to quickly make significant changes at the top, you need to understand how the changes may affect various parts of your company. While instinct may tell you to focus externally, don’t neglect your employees. Be as transparent as you possibly can be, present an action plan, ask for support, and get them involved in keeping the environment positive. Whether you bring in professionals or not, make sure you allow for questions, feedback, and even discord if challenging information is being revealed.  

6. Handle the media. Crisis rule #1 is making it clear who can, and who cannot, speak to the media. Assign a point person for all external inquiries and instruct employees to refer all reporter requests for comment to that point person. You absolutely do not want employees leaking sensitive information to the media. 
 
With your employees on board with the change management action plan, you can now focus on external communications and how you will present what is happening to the media. This is not completely under your control. Technology and social media changed the game in terms of speed and access to information to the public and transparency when it comes to corporate leadership. Present a message to the media quickly that coincides with your values as a company. If you are dealing with a scandal where public trust is involved and your CEO is stepping down, handling this effectively will take tact and most likely a team of professionals to help. 

Exit strategies are planning tools. Uncontrollable events occur and we don’t always get to follow our plan as we would have liked. Your organization can still be prepared and know what to do in an emergency situation or sudden crisis.  Executives move out of their roles every day, but how companies respond to these changes is reflective of the strategy in place to handle unexpected situations. Be as prepared as possible. Own your challenges. Stay accountable. 

BerryDunn can help whether you need extra assistance in your office during peak times or interim leadership support during periods of transition. We offer the expertise of a fully staffed accounting department for short-term assignments or long-term engagements―so you can focus on your business. Meet our interim assistance experts.

Read this if your CFO has recently departed, or if you're looking for a replacement.

With the post-Covid labor shortage, “the Great Resignation,” an aging workforce, and ongoing staffing concerns, almost every industry is facing challenges in hiring talented staff. To address these challenges, many organizations are hiring temporary or interim help—even for C-suite positions such as Chief Financial Officers (CFOs).

You may be thinking, “The CFO is a key business partner in advising and collaborating with the CEO and developing a long-term strategy for the organization; why would I hire a contractor to fill this most-important role?” Hiring an interim CFO may be a good option to consider in certain circumstances. Here are three situations where temporary help might be the best solution for your organization.

Your organization has grown

If your company has grown since you created your finance department, or your controller isn’t ready or suited for a promotion, bringing on an interim CFO can be a natural next step in your company’s evolution, without having to make a long-term commitment. It can allow you to take the time and fully understand what you need from the role — and what kind of person is the best fit for your company’s future.

BerryDunn's Kathy Parker, leader of the Boston-based Outsourced Accounting group, has worked with many companies to help them through periods of transition. "As companies grow, many need team members at various skill levels, which requires more money to pay for multiple full-time roles," she shared. "Obtaining interim CFO services allows a company to access different skill levels while paying a fraction of the cost. As the company grows, they can always scale its resources; the beauty of this model is the flexibility."

If your company is looking for greater financial skill or advice to expand into a new market, or turn around an underperforming division, you may want to bring on an outsourced CFO with a specific set of objectives and timeline in mind. You can bring someone on board to develop growth strategies, make course corrections, bring in new financing, and update operational processes, without necessarily needing to keep those skills in the organization once they finish their assignment. Your company benefits from this very specific skill set without the expense of having a talented but expensive resource on your permanent payroll.

Your CFO has resigned

The best-laid succession plans often go astray. If that’s the case when your CFO departs, your organization may need to outsource the CFO function to fill the gap. When your company loses the leader of company-wide financial functions, you may need to find someone who can come in with those skills and get right to work. While they may need guidance and support on specifics to your company, they should be able to adapt quickly and keep financial operations running smoothly. Articulating short-term goals and setting deadlines for naming a new CFO can help lay the foundation for a successful engagement.

You don’t have the budget for a full-time CFO

If your company is the right size to have a part-time CFO, outsourcing CFO functions can be less expensive than bringing on a full-time in-house CFO. Depending on your operational and financial rhythms, you may need the CFO role full-time in parts of the year, and not in others. Initially, an interim CFO can bring a new perspective from a professional who is coming in with fresh eyes and experience outside of your company.

After the immediate need or initial crisis passes, you can review your options. Once the temporary CFO’s agreement expires, you can bring someone new in depending on your needs, or keep the contract CFO in place by extending their assignment.

Considerations for hiring an interim CFO

Making the decision between hiring someone full-time or bringing in temporary contract help can be difficult. Although it oversimplifies the decision a bit, a good rule of thumb is: the more strategic the role will be, the more important it is that you have a long-term person in the job. CFOs can have a wide range of duties, including, but not limited to:

• Financial risk management, including planning and record-keeping
• Management of compliance and regulatory requirements
• Creating and monitoring reliable control systems
• Debt and equity financing
• Financial reporting to the Board of Directors

If the focus is primarily overseeing the financial functions of the organization and/or developing a skilled finance department, you can rely — at least initially — on a CFO for hire.

Regardless of what you choose to do, your decision will have an impact on the financial health of your organization — from avoiding finance department dissatisfaction or turnover to capitalizing on new market opportunities. Getting outside advice or a more objective view may be an important part of making the right choice for your company.

BerryDunn can help whether you need extra assistance in your office during peak times or interim leadership support during periods of transition. We offer the expertise of a fully staffed accounting department for short-term assignments or long-term engagements―so you can focus on your business. Meet our interim assistance experts.

So far in our value acceleration article series, we have talked about increasing the value of your business and building liquidity into your life starting with taking inventory of where you are at and aligning values, reducing risk, and increasing intangible value.

In this article, we are going to focus on planning and execution. How these action items are introduced and executed may be just as important as the action items themselves. We still need to protect value before we can help it grow. Let’s say you had a plan, a good plan, to sell your business and start a new one. Maybe a bed-and-breakfast on the coast? You’ve earmarked the 70% in cash proceeds to bolster your retirement accounts. The remaining 30% was designed to generate cash for the down payment on the bed-and-breakfast. And it is stuck in escrow or, worse yet, tied to an earn-out. Now, the waiting begins. When do you get to move on to the next phase? After all that hard work in the value acceleration process, you still didn’t get where you wanted to go. What went wrong?

Many business owners stumble at the end because they lack a master plan that incorporates their business action items and personal action items. Planning and execution in the value acceleration process was the focus of our conversation with a group of business owners and advisors on Thursday, April 11th.

Business valuation master plan steps to take

A master plan should include both business actions and personal actions. We uncovered a number of points that resonated with business owners in the room. Almost every business owner has some sort of action item related to employees, whether it’s hiring new employees, advancing employees into new roles, or helping employees succeed in their current roles. A review of financial practices may also benefit many businesses. For example, by revisiting variable vs. fixed costs, companies may improve their bidding process and enhance profitability. 

Master plan business improvement action items:

• Customer diversification and contract implementation
• Inventory management
• Use of relevant metrics and dashboards
• Financial history and projections
• Systems and process refinement

A comprehensive master plan should also include personal action items. Personal goals and objectives play a huge role in the actions taken by a business. As with the hypothetical bed-and-breakfast example, personal goals may influence your exit options and the selected deal structure. 

Master plan personal action items:

•  Family involvement in the business
•  Needs vs. wants
•  Development of an advisory team
•  Life after planning

A master plan incorporates all of the previously identified action items into an implementation timeline. Each master plan is different and reflects the underlying realities of the specific business. However, a practical framework to use as guidance is presented below.

The value acceleration process requires critical thinking and hard work. Just as important as identifying action items is creating a process to execute them effectively. Through proper planning and execution, we help our clients not only become wealthier but to use their wealth to better their lives. 

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations. 

What are the top three areas of improvement right now for your business? In this third article of our series, we will focus on how to increase business value by aligning values, decreasing risk, and improving what we call the “four C’s”: human capital, structural capital, social capital, and consumer capital.

To back up for a minute, value acceleration is the process of helping clients increase the value of their business and build liquidity into their lives. Previously, we looked at the Discover stage, in which business owners take inventory of their personal, financial, and business goals and assemble information into a prioritized action plan. Here, we are going to focus on the Prepare stage of the value acceleration process.

Aligning values may sound like an abstract concept, but it has a real world impact on business performance and profitability. For example, if a business has multiple owners with different future plans, the company can be pulled in two competing directions. Another example of poor alignment would be if a shareholder’s business plans (such as expanding the asset base to drive revenue) compete with personal plans (such as pulling money out of the business to fund retirement). Friction creates problems. The first step in the Prepare stage is therefore to reduce friction by aligning values.

Reducing risk

Personal risk creates business risk, and business risk creates personal risk. For example, if a business owner suddenly needs cash to fund unexpected medical bills, planned business expansion may be delayed to provide liquidity to the owner. If a key employee unexpectedly quits, the business owner may have to carve time away from their personal life to juggle new responsibilities. 

Business owners should therefore seek to reduce risk in their personal lives, (e.g., life insurance, use of wills, time management planning) and in their business, (e.g., employee contracts, customer contracts, supplier and customer diversification).

Intangible value and the four C's

Now more than ever, the value of a business is driven by intangible value rather than tangible asset value. One study found that intangible asset value made up 87% of S&P 500 market value in 2015 (up from 17% in 1975). Therefore, we look at how to increase business value by increasing intangible asset value and, specifically, the four C’s of intangible asset value: human capital, structural capital, social capital, and consumer capital. 

Here are two ways you can increase intangible asset value. First of all, do a cost-benefit analysis before implementing any strategies to boost intangible asset value. Second, to avoid employee burnout, break planned improvements into 90-day increments with specific targets.

At BerryDunn, we often diagram company performance on the underlying drivers of the 4 C’s (below). We use this tool to identify and assess the areas for greatest potential improvements:

By aligning values, decreasing risk, and improving the four C’s, business owners can achieve a spike in cash flow and business value, and obtain liquidity to fund their plans outside of their business.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

This is our second of five articles addressing the many aspects of business valuation. In the first article, we presented an overview of the three stages of the value acceleration process (Discover, Prepare, and Decide). In this article we are going to look more closely at the Discover stage of the process.

In the Discover stage, business owners take inventory of their personal, financial, and business goals, noting ways to increase alignment and reduce risk. The objective of the Discover stage is to gather data and assemble information into a prioritized action plan, using the following general framework.

Every client we have talked to so far has plans and priorities outside of their business. Accordingly, the first topic in the Discover stage is to explore your personal plans and how they may affect business goals and operations. What do you want to do next in your personal life? How will you get it done?

Another area to explore is your personal financial plan, and how this interacts with your personal goals and business plans. What do you currently have? How much do you need to fund your other goals?

The third leg of the value acceleration “three-legged stool” is business goals. How much can the business contribute to your other goals? How much do you need from your business? What are the strengths and weaknesses of your business? How do these compare to other businesses? How can business value be enhanced? A business valuation can help you to answer these questions.

A business valuation can clarify the standing of your business regarding the qualities buyers find attractive. Relevant business attractiveness factors include the following:

• Market factors, such as barriers to entry, competitive advantages, market leadership, economic prosperity, and market growth
• Forecast factors, such as potential profit and revenue growth, revenue stream predictability, and whether or not revenue comes from recurring sources
• Business factors, such as years of operation, management strength, customer loyalty, branding, customer database, intellectual property/technology, staff contracts, location, business owner reliance, marketing systems, and business systems

Your company’s performance in these areas may lead to a gap between what your business is worth and what it could be worth. Armed with the information from this assessment, you can prepare a plan to address this “value gap” and look toward your plans for the future.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Next up in our value acceleration series is all about what we call the four C's of the value acceleration process. 

This is the first article in our five-article series that reviews the art and science of business valuation. The series is based on an in-person program we offer from time to time.  

Did you know that just 12 months after selling, three out of four business owners surveyed “profoundly regretted” their decision? Situations like these highlight the importance of the value acceleration process, which focuses on increasing value and aligning business, personal, and financial goals. Through this process, business owners will be better prepared for business transitions, and therefore be significantly more satisfied with their decisions.

Here is a high-level overview of the value acceleration process. This process has three stages, diagrammed here:

The Discover stage is also called the “triggering event.” This is where business owners take inventory of their situation, focusing on risk reduction and alignment of their business, personal, and financial goals. The information gleaned in this stage is then compiled into a prioritized action plan utilized in future stages.

In the Prepare stage, business owners follow through on business improvement and personal/financial planning action items formed in the discover stage. Examples of action items include the following:

• Addressing weaknesses identified in the Discover stage, in the business, or in personal financial planning
• Protecting value through planning documents and making sure appropriate insurance is in place
• Analyzing and prioritizing projects to improve the value of the business, as identified in Discover stage
• Developing strategies to increase liquidity and retirement savings

The last stage in the process is the Decide stage. At this point, business owners choose between continuing to drive additional value into the business or to sell it.

Through the value acceleration process, we help business owners build value into their businesses and liquidity into their lives.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Read more! In our next installment of the value acceleration blog series, we cover the Discover stage.

This article is the first in a series to help employee benefit plan fiduciaries better understand their responsibilities and manage the risks of non-compliance with ERISA requirements.

On Labor Day, 1974, President Gerald Ford signed the Employee Retirement Income Security Act, commonly known as ERISA, into law. Prior to ERISA, employee pensions had scant protections under the law, a problem made clear when the Studebaker automobile company closed its South Bend, Indiana production plant in 1963. Upon the plant’s closing, some 4,000 employees—whose average age was 52 and average length of service with the company was 23 years—received approximately 15 cents for each dollar of benefit they were owed. Nearly 3,000 additional employees, all of whom had less than 10 years of service with the company, received nothing.

A decade later, ERISA established statutory requirements to preserve and protect the rights of employees to their pensions upon retirement. Among other things, ERISA defines what a plan fiduciary is and sets standards for their conduct.

Who is—and who isn’t—a plan fiduciary?
ERISA defines a fiduciary as a person who:

1. Exercises discretionary authority or control over the management of an employee benefit plan or the disposition of its assets,
2. Gives investment advice about plan funds or property for a fee or compensation or has the authority to do so,
3. Has discretionary authority or responsibility in plan administration, or
4. Is designated by a named fiduciary to carry out fiduciary responsibility. (ERISA requires the naming of one or more fiduciaries to be responsible for managing the plan's administration, usually a plan administrator or administrative committee, though the plan administrator may engage others to perform some administrative duties).

If you’re still unsure about exactly who is and isn’t a plan fiduciary, don’t worry, you’re not alone. Disagreements over whether or not a person acting in a certain capacity and in a specific situation is a fiduciary have sometimes required legal proceedings to resolve them. Here are some real-world examples.

Employers who maintain employee benefit plans are typically considered fiduciaries by virtue of being named fiduciaries or by acting as a functional fiduciary. Accordingly, employer decisions on how to execute the intent of the plan are subject to ERISA’s fiduciary standards.

Similarly, based on case law, lawyers and consultants who effectually manage an employee benefit plan are also generally considered fiduciaries.

A person or company that performs purely administrative duties within the framework, rules, and procedures established by others is not a fiduciary. Examples of such duties include collecting contributions, maintaining participants' service and employment records, calculating benefits, processing claims, and preparing government reports and employee communications.

What are a fiduciary’s responsibilities?
ERISA requires fiduciaries to discharge their duties solely in the interest of plan participants and beneficiaries, and for the exclusive purpose of providing benefits for them and defraying reasonable plan administrative expenses. Specifically, fiduciaries must perform their duties as follows:

1. With the care, skill, prudence, and diligence of a prudent person under the circumstances;
2. In accordance with plan documents and instruments, insofar as they are consistent with the provisions of ERISA; and
3. By diversifying plan investments so as to minimize risk of loss under the circumstances, unless it is clearly prudent not to do so.

A fiduciary is personally liable to the plan for losses resulting from a breach of their fiduciary responsibility, and must restore to the plan any profits realized on misuse of plan assets. Not only is a fiduciary liable for their own breaches, but also if they have knowledge of another fiduciary's breach and either conceals it or does not make reasonable efforts to remedy it.

ERISA provides for a mandatory civil penalty against a fiduciary who breaches a fiduciary responsibility under ERISA or commits a violation, or against any other person who knowingly participates in such breach or violation. That penalty is equal to 20 percent of the "applicable recovery amount" paid pursuant to any settlement agreement with ERISA or ordered by a court to be paid in a judicial proceeding instituted by ERISA.

ERISA also permits a civil action to be brought by a participant, beneficiary, or other fiduciary against a fiduciary for a breach of duty. ERISA allows participants to bring suit to recover losses from fiduciary breaches that impair the value of the plan assets held in their individual accounts, even if the financial solvency of the entire plan is not threatened by the alleged fiduciary breach. Courts may require other appropriate relief, including removal of the fiduciary.

Over the coming months, we’ll share a series of blogs for employee benefit plan fiduciaries, covering everything from common terminology to best practices for plan documentation, suggestions for navigating fiduciary risks, and more.

For over four years the business community has been discussing the impact Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, will have on financial reporting. As you evaluate the impact this standard will have on a manufacturers’ financial reporting practices, there are certain provisions of ASC 606 you should consider.

Then: Prior to ASC 606, manufacturers generally recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fees are fixed or determinable, and collection is reasonably assured. For most, this typically occurs when a product ships and the title to the product transfers to the customer.

Now: Under ASC 606, effective for annual reporting periods beginning after December 15, 2018 for non-public entities (December 15, 2017 for public entities), an entity should recognize revenue 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 those goods or services. Under this core principle, an entity should:

1. Identify its contracts with its customers,
2. Identify performance obligations (promises) in the contract,
3. Determine the transaction price,
4. Allocate the transaction price to the performance obligations in the contract; and
5. Recognize revenue when (or as) the entity satisfies the performance obligation. 

Who does it impact, and how?

For some manufacturers, ASC 606 will not impact their financial reporting practices since they satisfy their performance obligation when the product is shipped and the title has transferred to the customer. However, entities who manufacture highly specialized products may be required to recognize revenue over time if the entity’s performance creates an asset without an alternative use to the entity, and the entity has an enforceable right to compensation for performance completed to date.

Limitations

To determine if a product has an alternative use, the entity must assess whether it is restricted contractually from redirecting the asset for another use during production, or if there are practical limitations on the entity’s ability to redirect the product for another use. A contractual limitation must be substantive for it to be determined to not have an alternative use, e.g., the customer can enforce rights for delivery of the product. A restriction is not substantive if the product is largely interchangeable with other products the entity could transfer between customers without incurring a significant loss.

A practical limitation exists if the entity’s ability to redirect the product for another use results in significant economic losses, either from significant rework costs or having to sell the product at a loss. The alternative use assessment should be done at contract inception based on the product in its completed state, and not during the production process. Therefore, the point in time during production when a product becomes customized and not generic is irrelevant. If it is determined there is no alternative use, the entity has satisfied this criterion and must evaluate its enforceable right to compensation for performance completed to date.

Definitions and Distinctions

ASC 606 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations”. Accordingly, the definition of a contract may include, but not be limited to, a Purchase Order, Agreement for the Sale of Goods, Bill of Sale, Independent Contractor Agreement, etc. In applying this definition to business operations and revenue recognition, an entity must consider its individual business practices, and possibly individual customer arrangements in determining enforceability.

Once it is determined that the entity has an enforceable right to a payment, the amount of payment must also be considered. The amount that would “compensate” an entity for performance to date should be the estimated selling price of the goods or services transferred to date (for example, recovery of costs incurred plus a reasonable profit margin) rather than compensation for only the entity’s potential loss of profit if the contract were to be terminated. Accordingly, a payment that only covers the entity’s costs incurred to date or for the entity’s potential loss of profit if the contract was terminated does not allow for the recognition of revenue over time.

Compensation for a reasonable profit margin need not equal the profit margin expected if the contract was fulfilled as promised. Once the “enforceable right to compensation for performance completed to date” requirement has been met, an entity will then assess the appropriate method of recognizing revenue over a period of time using input or output methods, as provided under ASC 606.

For manufacturers of highly specialized products there may not be a simple answer for determining appropriate revenue recognition policies for each customer contract and evaluating the impact can be a challenging endeavor.

Next steps

If you would like guidance in analyzing the impact ASC 606 will have on a manufacturer’s financial reporting practices, including the potential impact it may have on bank covenants, borrowing base calculations, etc., please contact one of our dedicated commercial industry practice professionals.