Problems with revenue recognition

Revenue. It’s the top line on financial statements, and arguably the most important. But, revenue is not always comparable between companies, since the amount reported depends on when the company recognizes the revenue as earned, not when it’s received. What constitutes “when” can lead to significant debate. Improvements in accounting rules have been announced, but advisors will have to wait two years before seeing their full impact.

The current challenges

Any company can use the new rules on a voluntary basis. Investors need to look for early adopters, while also remaining vigilant of the shortfalls in the current rules. How companies transition to the new rules will also significantly impact trend analysis and any quant-based models or systems.

Revenue recognition rules have traditionally had two problem areas: multi-year projects and multi-component transactions.

1. Projects that stretch over multiple years

For instance, long-term infrastructure projects can have fixed or variable costs, multiple deadlines, and uneven cash receipts and expense payments. They can also provide a mix of both goods and services. These factors make it difficult to estimate when revenue should be recorded, and in what amounts.

Construction programs, such as those for new aircraft, can take decades to design, test and deliver. Sometimes, design costs can be shared across various programs. Similarly, entertainment projects can involve shared costs from both production and marketing perspectives.

2. Products and services with multiple deliverables

A prime example of multiple deliverables can be seen in technology companies that provide a combination of hardware, software, consulting, servicing, support, upgrades and warranties—sometimes all in one. These products and services can be interdependent, so it’s difficult to measure the revenue that they earn every quarter over an extended period.

While these descriptions only scratch the surface, one of accounting’s guidelines has always been that revenues should be matched to expenses. For this to occur, the costs need to be known and measurable. This often results in cash payments being timed differently from when revenue is recorded.

What the new rules address

The new rules were finalized last year, so the upcoming slate of annual reports will be the first opportunity companies will have to disclose the rules’ potential impact on their financial statements. Not all industries or companies will be affected—some might not see any impact.

For instance, the new rules only alter the accounting for specific situations and more complicated scenarios. Even companies in the same industry can be different in substance and product offering, so investors will need to focus on the corporate level to avoid making analytical and comparability mistakes when it comes to valuation. Some companies will see their revenue and topline figures altered significantly, and others, not at all.

Apple Inc. has changed its revenue recognition policies in the past few years, since it provides software upgrades to customers for free after they’ve made purchases. As they started to do so, the company began to defer an increasing proportion of revenue related to each device sold. This was a forward-looking voluntary change that impacted reported revenue growth and profit margin—both key factors monitored closely by the market.

Another industry expected to see major impacts from the changes is the telecom space. Currently, cell phone providers sign many customers to contracts that are tied to new handsets. There are cost subsidies involved, and some phones are sold for free (no money down, in actuality).

Previously, companies generally broke down revenue based on the price of the phone, as opposed to its actual value. While this seems like a subtle difference, the impact will be significant, unless the industry reduces the subsidies handed out to customers.

Under the new rules, their accounting would have to break the bundled contract into deliverable parts, so the fulfillment of providing the phone to the customer would constitute revenue generation in the amount of the estimated value of the handset. Companies would end up reporting significantly more revenue up front, not later when the customer actually pays for the phone in installments. This may seem counterintuitive, and could be regarded as a significant drawback to achieving the stated goal of greater accounting harmonization. Telecom providers, in particular, lobbied hard against the accounting changes (indicating the quantum of the disruptive impact the rules will bring).

While the new rules improve IFRS and harmonize reporting with U.S. guidelines, there will still be significant challenges regarding implementation. There will be debates over who the actual customer is in certain situations.

Other transactions will be bogged down by details, like whether something constitutes a product warranty or a service warranty. So, these issues will need to be resolved with significant estimations and judgment calls by management, likely degrading some of the comparability that was the primary aim of the decade-long accounting project.