Tax planning strategies for

year-end

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.

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.

As construction companies look for new ways to cut costs, the annual bonus is often one of the first items on the chopping block.

Rather than eliminating financial incentives, consider developing an incentive compensation program that’s designed to help achieve your firm’s goals.

Here are five tips for designing a program that works.

1. Reward the right things 
   Incentive programs frequently backfire because companies reward employees for the wrong things. Bonuses tied strictly to profits, for example, can motivate employees to adopt short-term strategies that increase their pay at the expense of the firm’s long-term performance.
   
   Unfortunately, short-term strategies sometimes sacrifice quality or safety to boost profits. Cutting corners on jobs may create short-term savings, but could hurt the firm’s bottom line over the long run. Safety issues can threaten a contractor’s very existence. 
   
   Instead, tie compensation to all aspects of an employee’s job. When designing an incentive program for superintendents, for example, reward projects that get done on time and within budget—while maintaining quality and safety standards. If you offer bonuses only for staying on schedule, then cost, quality and safety may suffer. Instead, make sure your program rewards excellence in all four areas.
    
2. Link pay to results 
   For incentive compensation to work, it’s critical to reward employees for achieving quantifiable results that are within their control. Discretionary annual bonus plans are often ineffective because employees typically view bonuses as a “gift” rather than a reward for good performance. If year-end bonuses become an expected component of compensation, not only are they poor motivators, but they can quickly turn into “demotivators” should they be reduced or taken away.
   
   Establish performance goals that are attainable with hard work, but not too easily achieved. The goals should be simple and straightforward enough so that employees understand both what they’re expected to do and what they stand to gain if they do it. Sometimes companies create incentive pay formulas that are so complex and difficult to understand that employees become disillusioned with the program. As you develop your plan, seek input from eligible participants to gain employee buy-in.
    
3. Establish benchmarks
   The only way to gauge employee performance is to measure your firm’s recent performance and establish goals for improvement. You can’t reward employees for reducing the time to completion unless you know your average building time on similar jobs. 
   
   To reward cost reduction, for example, you might measure decreases in labor hours or overtime. To reward quality improvement, you might track defects per square foot or amounts spent on warranty calls. The right benchmarks depend on the nature of your firm and its specific goals.
    
4. Time it right
   For your incentive program to be truly effective, timing is everything. To maximize the impact, compensation should be linked closely in time with the performance that earned it—by paying bonuses quarterly, for example, rather than annually.
   
   Consider deferring part of the bonus, however, to reflect future events that bear on an employee’s performance. Some firms hold back a portion of the bonus and reduce it based on warranty expenses during the year following a project’s completion, for example.
    
5. Think long term
   To align your employees’ interests with the company’s long-term goals, consider using stock options, restricted stock or other equity-based awards. Giving employees an ownership stake in the business provides them with a financial incentive to stay with the company and maximize its long-term value. 
   
   To be effective, these incentives should vest over a substantial period of time. Otherwise, they might encourage actions that artificially boost the value of the company’s stock or other equity interests in the short term.  And be sure to discuss these with your accounting and tax advisors before implementation—these awards come with some accounting and reporting requirements and may also trigger tax consequences.  

Tying it all together
By tying compensation to performance, you can identify, motivate and retain your most valuable employees. Unlike across-the-board bonuses, a carefully targeted incentive program can pay for itself. Some contractors have even convinced employees to accept lower base salaries in exchange for an opportunity to earn higher performance pay.

A common pitfall for inbound sellers is applying the same concepts used to adopt “no tax” positions made for federal income tax purposes to determinations concerning sales and use tax compliance. Although similar conceptually, separate analyses are required for each determination.

For federal income tax purposes, inbound sellers that are selling goods to customers in the U.S. and do not have a fixed place of business or dependent agent in the U.S. have, traditionally, been able to rely on their country’s income tax treaty with the U.S. for “no tax” positions. Provided that the non-U.S. entity did not have a “permanent establishment” in the U.S., it was shielded from federal income tax and would have a limited federal income tax compliance obligation.

States, however, are generally not bound by comprehensive income tax treaties made with the U.S. Thus, non-U.S. entities can find themselves unwittingly subject to state and local sales and use tax compliance obligations even though they are protected from a federal income tax perspective. With recent changes in U.S. tax law, the burden of complying with sales and use tax filing and collection requirements has increased significantly.

Does your company have a process in place to deal with these new state and local tax compliance obligations?

What has changed? Wayfair—it’s got what a state needs

As a result of the Supreme Court’s ruling in South Dakota v. Wayfair, Inc., non-U.S. entities that have sales to customers in the U.S. may have unexpected sales and use tax filing obligations on a go-forward basis. Historically, non-U.S. entities did not have a sales and use tax compliance obligation when they did not have a physical presence in states where the sales occurred.

In Wayfair, the U.S. Supreme Court ruled that a state is no longer bound by the physical presence standard in order for it to impose its sales and use tax regime on entities making sales within the state. The prior physical presence standard was set forth in precedent established by the Supreme Court and was used to determine if an entity had sufficient connection with a state (i.e., nexus) to necessitate a tax filing and collection requirement.

Before the Wayfair ruling, an entity had to have a physical presence (generally either through employees or property located in a state) in order to be deemed to have nexus with the state. The Wayfair ruling overturned this precedent, eliminating the physical presence requirement. Now, a state can deem an entity to have nexus with the state merely for exceeding a certain level of sales or transactions with in-state customers. This is a concept referred to as “economic nexus.”

The Court in Wayfair determined that the state law in South Dakota providing a threshold of $100,000 in sales or more than 200 sale transactions occurring within the state is sufficient for economic nexus to exist with the state. This is good news for hard-pressed states and municipalities in search of more revenue. Since this ruling, there has been a flurry of new state legislation across the country. Like South Dakota, states are actively passing tax laws with similar bright-line tests to determine when entities have economic nexus and, therefore, a sales and use tax collection and filing requirement.

How this impacts non-U.S. entities

This can be a trap for non-U.S. entities making sales to customers in the U.S. Historically, non-U.S. entities lacking a U.S. physical presence generally only needed to navigate federal income tax rules.

Inbound sellers without a physical presence in the U.S. may have very limited experience with state and local tax compliance obligations. When considering all of the state and local tax jurisdictions that exist in the U.S. (according to the Tax Foundation there are more than 10,000 sales tax jurisdictions), the number of sales and use tax filing obligations can be significant. Depending on the level of sales activity within the U.S., a non-U.S. entity can quickly become inundated with the time and cost of sales and use tax compliance.

Next steps

Going forward, non-U.S. entities selling to customers in the U.S. should be aware of those states that have economic nexus thresholds and adopt procedures so they are prepared for their sales and use tax compliance obligations in real time. These tax compliance obligations will generally require an entity to register to do business in the state, collect sales tax from customers, and file regular tax returns, usually monthly or quarterly.

It is important to note when an entity has an obligation to collect sales tax, it will be liable for any sales tax due to a state, regardless of whether the sales tax is actually collected from the customer. It is imperative to stay abreast of these complex legislative changes in order to be compliant.

At BerryDunn, our tax professionals work with a number of non-U.S. companies that face international, state, and local tax issues. If you would like to discuss your particular circumstances, contact one of the experienced professionals in our state and local tax (“SALT”) practice.

IRS Notice 2018-67 Hits the Charts
Last week, in addition to The Eagles Greatest Hits (1971-1975) album becoming the highest selling album of all time, overtaking Michael Jackson’s Thriller, the IRS issued Notice 2018-67—its first formal guidance on Internal Revenue Code Section 512(a)(6), one of two major code sections added by the Tax Cuts and Jobs Act of 2017 that directly impacts tax-exempt organizations. Will it too, be a big hit? It remains to be seen.

Section 512(a)(6) specifically deals with the reporting requirements for not-for-profit organizations carrying on multiple unrelated business income (UBI) activities. Here, we will summarize the notice and help you to gain an understanding of the IRS’s thoughts and anticipated approaches to implementing §512(a)(6).

While there have been some (not so quiet) grumblings from the not-for-profit sector about guidance on Code Section 512(a)(7) (aka the parking lot tax), unfortunately we still have not seen anything yet. With Notice 2018-67’s release last week, we’re optimistic that guidance may be on the way and will let you know as soon as we see anything from the IRS.

Before we dive in, it’s important to note last week’s notice is just that—a notice, not a Revenue Procedure or some other substantive legislation. While the notice can, and should be relied upon until we receive further guidance, everything in the notice is open to public comment and/or subject to change. With that, here are some highlights:

No More Netting
512(a)(6) requires the organization to calculate unrelated business taxable income (UBTI), including for purposes of determining any net operating loss (NOL) deduction, separately with respect to each such trade or business. The notice requires this separate reporting (or silo-ing) of activities in order to determine activities with net income from those with net losses.

Under the old rules, if an organization had two UBI activities in a given year, (e.g., one with $1,000 of net income and another with $1,000 net loss, you could simply net the two together on Form 990-T and report $0 UBTI for the year. That is no longer the case. From now on, you can effectively ignore activities with a current year loss, prompting the organization to report $1,000 as taxable UBI, and pay associated federal and state income taxes, while the activity with the $1,000 loss will get “hung-up” as an NOL specific to that activity and carried forward until said activity generates a net income.

Separate Trade or Business
So, how does one distinguish (or silo) a separate trade or business from another? The Treasury Department and IRS intend to propose some regulations in the near future, but for now recommend that organizations use a “reasonable good-faith interpretation”, which for now includes using the North American Industry Classification System (NAICS) in order to determine different UBI activities.

For those not familiar, the NAICS categorizes different lines of business with a six-digit code. For example, the NAICS code for renting* out a residential building or dwelling is 531110, while the code for operating a potato farm is 111211. While distinguishing residential rental activities from potato farming activities might be rather straight forward, the waters become muddier if an organization rents both a residential property and a nonresidential property (NAICS code 531120). Does this mean the organization has two separate UBI rental activities, or can both be grouped together as rental activities? The notice does not provide anything definitive, but rather is requesting public comments?we expect to see something more concrete once the public comment period is over.

*In the above example, we’re assuming the rental properties are debt-financed, prompting a portion of the rental activity to be treated as UBI.

UBI from Partnership Investments (Schedule K-1)
Notice 2018-67 does address how to categorize/group unrelated business income for organizations that receive more than one partnership K-1 with UBI reported. In short, if the Schedule K-1s the organization receives can meet either of the tests below, the organization may treat the partnership investments as a single activity/silo for UBI reporting purposes. The notice offers the following:

De Minimis Test
You can aggregate UBI from multiple K-1s together as long as the exempt organization holds directly no more than 2% of the profits interest and no more that 2% of the capital interest. These percentages can be found on the face of the Schedule K-1 from the Partnership and the notice states those percentages as shown can be used for this determination. Additionally, the notice allows organizations to use an average of beginning of year and end of year percentages for this determination.

Ex: If an organization receives a K-1 with UBI reported, and the beginning of year profit & capital percentages are 3%, and the end of year percentages are 1%, the average for the year is 2% (3% + 1% = 4%/2 = 2%). In this example, the K-1 meets the de minimis test.

There is a bit of a caveat here—when determining an exempt organization's partnership interest, the interest of a disqualified person (i.e. officers, directors, trustees, substantial contributors, and family members of any of those listed here), a supporting organization, or a controlled entity in the same partnership will be taken into account. Organizations need to review all K-1s received and inquire with the appropriate person(s) to determine if they meet the terms of the de minimis test.

Control Test
If an organization is not able to pass the de minimis test, you may instead use the control test. An organization meets the requirements of the control test if the exempt organization (i) directly holds no more than 20 percent of the capital interest; and (ii) does not have control or influence over the partnership.

When determining control or influence over the partnership, you need to apply all relevant facts and circumstances. The notice states:

“An exempt organization has control or influence if the exempt organization may require the partnership to perform, or may prevent the partnership from performing, any act that significantly affects the operations of the partnership. An exempt organization also has control or influence over a partnership if any of the exempt organization's officers, directors, trustees, or employees have rights to participate in the management of the partnership or conduct the partnership's business at any time, or if the exempt organization has the power to appoint or remove any of the partnership's officers, directors, trustees, or employees.”

As noted above, we recommend your organization review any K-1s you currently receive. It’s important to take a look at Line I1 and make sure your organization is listed here as “Exempt Organization”. All too often we see not-for-profit organizations listed as “Corporations”, which while usually technically correct, this designation is really for a for-profit corporation and could result in the organization not receiving the necessary information in order to determine what portion, if any, of income/loss is attributable to UBI.

Net Operating Losses
The notice also provides some guidance regarding the use of NOLs. The good news is that any pre-2018 NOLs are grandfathered under the old rules and can be used to offset total UBTI on Form 990-T.

Conversely, any NOLs generated post-2018 are going to be considered silo-specific, with the intent being that the NOL will only be applicable to the activity which gave rise to the loss. There is also a limitation on post-2018 NOLs, allowing you to use only 80% of the NOL for a given activity. Said another way, an activity that has net UBTI in a given year, even with post-2017 NOLs, will still potentially have an associated tax liability for the year.

Obviously, Notice 2018-67 provides a good baseline for general information, but the details will be forthcoming, and we will know then if they have a hit. Hopefully the IRS will not Take It To The Limit in terms of issuing formal guidance in regards to 512(a)(6) & (7). Until they receive further IRS guidance,  folks in the not-for-profit sector will not be able to Take It Easy or have any semblance of a Peaceful Easy Feeling. Stay tuned.

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.