This article originally appeared on June 21st, 2017 and is authored by Michael Cohn of Accounting Today.
Investors need to watch out for revenue recognition changes
With the new revenue recognition standard taking effect next year, companies and their investors are bound to see some dramatic changes in the topline numbers being reported.
The Financial Accounting Standards Board and the International Accounting Standards Board have done their best to harmonize their revenue recognition standards, and prepare accountants, investors and companies for the changes ahead. But there will still be a number of areas that will be likely to raise eyebrows.
Vincent Papa, director of financial reporting policy at CFA Institute, a global association of investment professionals, has written two recent white papers highlighting some of the main areas for investor scrutiny, Watching the “Top Line”, and Investor Considerations in Run-Up to 2018. He believes investors need to be aware of issues such as multiple deliverables within a contract, license revenue, gross versus net presentation of revenue, customer credit risk, and special concerns with long-term contracts, including revenue recognition over time, significant financing components and additional cost recognition.
“Revenue is a pervasive metric,” he told Accounting Today. “It is the top line. It’s important in its own right, but it also has an impact on the other key metrics, like earnings and any other intermediate metric margin.”
He pointed to the risks of financial restatements and the types of judgments that go along with recognizing revenue.
“There’s always the risk of investors being misled by the reporting of revenue,” said Papa. “The standard that’s been updated by the IASB and in the U.S. the Financial Accounting Standards Board is a joint project. It’s a converged standard. It’s highly judgement intensive.”
Timing can be uncertain in terms of recognizing revenue, he noted. “There is also an implication Save on the amount of revenue, the timing, as well as the uncertainty,” said Papa. “That’s certainly an aspect of importance to investors, particularly as it becomes not so clear-cut or it is not always self-evident as to what the impact should be as far as timing is concerned. There are particular sectors where you have an acceleration of revenue, but in other cases you have the deferral of revenue occurring.”
Another important aspect is the cost recognition requirements in the new standard. “That could also affect the gross margin, which is revenue minus the cost of sales,” said Papa. “To the extent that there is a turning up of the revenue recognition part vis a vis the cost recognition part, then you’d anticipate that there would be a smoothening of the gross margins, but you could also have scenarios where it’s not quite playing out. It’s important for investors to have a sense of the implications of the cost recognition requirements, how it may affect particular business models like the aerospace industry, for example.”
In the case of an aerospace company, program accounting versus unit accounting could affect the margin profile. He pointed to a recent study by Georgia Tech that looked at the quality of disclosures in the aerospace industry around percentage of completion and found them to be wanting.
“Another aspect is correlation and the relationship between cash flow from operations and the margins,” Papa added. “A fourth component would be the disclosures. There are more disclosures being provided by the new standard, and clearly they’re strengthening the level of transparency around revenue. The question is whether these disclosures really go far enough, particularly where the more forward-looking information is concerned.”
Papa acknowledged that many business models will not be affected as much by the new requirements, especially those that tend to have fixed prices or determinable quantities of goods and services, such as point of sale transactions. “In those cases revenue is not going to change with the new requirements,” he said.
On the other hand, more complicated contracts will see a greater impact from the new standard, particularly long-duration contracts with multiple elements, products, licenses and services within the same contract. Examples of those can occur in the software, telecommunications and pharmaceuticals industries. When there’s variation in the price of quantities on a forward-looking basis, such as a semiconductor company using distributors, and there is a risk of obsolescence when the goods are with the distributor, or there is a level of price uncertainty, and it’s not clear what has been parceled out to the distributor and what corresponds to the ultimate sale, that too can lead to uncertainty.
“That’s one area where there would be sales or revenue uncertainty on non-cash consideration,” said Papa. “All these types of complex elements within contracts, these are the aspects that could have a bearing on the amount and timing and uncertainty of revenue. Investors need to have very business model-specific understanding to really get a sense of how revenue is going to be changed. Is it going to be accelerated or is it going to be deferred as a result of the new requirements?”
The disclosures are meant to be more robust than what is currently in place, he noted. “There is an anticipation that there will be a ramping up of the quality of disclosures, but it really depends on the extent to which the preparers conform with the spirit of the requirements rather than potentially taking a minimalist approach and perhaps using aspects of the requirements to avoid providing disclosures,” he said. “For example, on how contract boundaries are defined, you may get a situation where there’s no need to provide disclosures based on how the contract boundaries have been defined. There could be situations where what’s being disclosed is not exhaustive on the order backlog, or the future revenue potential. It could just be presenting part of the picture, so there is always that risk.”
The new standard also leans heavily on professional judgment, offering considerable leeway to companies and their accountants.
“When you consider all this complex judgment, the requirements don’t go into detail and say in every instance you need to disclose this judgment or that judgment,” said Papa. “It’s just a general requirement to disclose significant judgment and estimates that are made. Take something like significant financing components. When a customer pays less, but pays much earlier, the requirements are such that one makes a judgment that there is a significant financing with an implication on interest, for example, but the aspect also of what’s the effective interest rate that has been applied in that significant financing component calculation is being made. The requirements don’t say to give that, but that’s what’s going to be of interest. To the extent that preparers provide these key judgments, that will make it more informative, but the anticipation is that more disclosure should be better than where we are today.”
Amy Hover, managing director at MorganFranklin’s accounting and transaction services, also points to the principles-based nature of the new standard.
“The guidance is principles based,” she said. “It’s not rules based, so there is some judgment in there. Companies are looking at it today. I’d like to say most have a handle around the technical positions, and are then understanding how to operationalize. There are still a few companies that could be at ground zero. It’s really important to get their technical accounting positions in place, and understand the principles, not rules, and where do they want to apply certain judgments. A few examples could be assessing whether the options in a contract should be accounted for as a material right or estimating the variable considerations at the outset of an arrangement. But it is certainly principles based, and companies need to make sure that they are putting pen to paper on their technical accounting positions.”
The Securities and Exchange Commission has cautioned companies and accountants to be sure to provide the appropriate disclosures under the new standard. “The SEC has actually emphasized the importance of companies giving more disclosures, as well as in the run-up to the adoption of the standard,” said Papa. “They’re really telling us investors the implications of the new requirements on the actual revenue. The current chief accountant, Wesley Bricker, when he was acting chief accountant, made a speech last year where he was emphasizing the importance of being fully transparent with investors and making investors aware of the implications of this new requirements. Clearly there’s a signal that they’ll be paying attention, which they have done in the past as well. Revenue has been one of the areas where you tend to get comment letters on and clearly some level of SEC oversight, so we anticipate that the same should continue to occur.”
He pointed out that the nature of the contracts may change in response to the new standard. “To the extent to which business models have an anticipatory adjustment to the contract they’ve got in place in a manner that has an impact on the revenue, the timing of the revenue is something that investors also need to be aware of,” Papa noted.
Some telecommunications companies and technology providers may decide to adjust their contracts. “There has been this migration to software as a service, the SaaS model,” said Papa. “That’s more like subscription type revenue, so the components of those contracts can be seen as a bundled product. Revenue tends to be recognized over time, as opposed to the old model where you got a license and a lot of revenue is recognized upfront. There will the question of whether in the context of how these contracts are defined there will be an alteration of the nature of the contract. All these kinds of alterations that are occurring as a result of an anticipatory sense into the revenue recognition requirements, that’s important for investors to track—the business model, contract, how it affects revenue and how that then plays down in costs as well, margin, cash flow, you need to have that total picture when you’re analyzing.”