New Revenue Recognition Accounting Standard: What Investors Need to Know

The revenue companies report matters a great deal to investors. As a result, CFA Institute recently hosted a webcast featuring International Accounting Standards Board (IASB) board member Patrick Finnegan and Financial Accounting Standard Board (FASB) board member Marc Siegel on what new revenue recognition rules mean for investors. The webcast — which you can access here — addressed the following:

• An overview of the newly released revenue recognition standard and how it impacts investors.
• Questions investors should consider as a part of their analysis and evaluation of companies
• Areas of greatest potential impact for change

 Why Revenue Matters and Background to Changes

Revenue is the starting point for defining all variants of income (core earnings, net income, etc.), and it is the single-most potent indicator of the economic-value creation potential of any business model. Revenue influences almost all key income statement analytical ratios, including a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA); net income and related metrics (return on equity and return on assets); and balance sheet-based ratios that gauge asset utilization, solvency, and working capital management. At the same time, we’ve seen countless episodes of egregious earnings management and frequent revenue restatements.

There are several big-picture objectives that shaped the issuance of the new revenue recognition standard, including:

• Convergence: This standard is the first successfully completed joint project between FASB and IASB under the 2002 Memorandum of Understanding, which demonstrates the potential for convergence.
• Less Industry Guidance: It establishes robust principles that curtail the need for industry-specific guidance that is prevalent in the United States.
• Filling Gaps in Existing International Financial Reporting Standards (IFRS): The rule addresses areas in which there was nonexistent or incomplete guidance under IFRS, such as the accounting for multiple-element contracts.

Need for Investor Attention in Run-up to Effective Date

The key message from the recent webcast was the need for investors to closely track the reporting outcomes of the new revenue standard relative to existing guidance and the transition requirements. The new standard will go into effect on 1 January 2017 under IFRS and 15 December 2016 under US generally accepted accounting principles (GAAP). IFRS allows early application, but US GAAP does not. The standard gives preparers the choice between providing retrospective transition (i.e., 2017 and two prior years) and prospective transition (current year, no prior year, and disclosure of what current revenue would have been under the old guidance). Monitoring revenue by investors prior to the effective date will help them discern the impact of changes because some companies may already begin altering their revenue recognition practices.

We polled webcast participants, and the results showed significant differences in expectations and preferences for information in the run-up to the effective dates for the new standard and during the transition period. The feedback included:

• 64% of poll respondents said they would pay greater attention to the standard in the 12-to-30 month period prior to the effective date.
• A majority of poll respondents said management should begin disclosing in financial statements the potential impact of the change in the revenue recognition standard before the new rules take effect, with 88% preferring such disclosures in the 12 to 30 months prior to the standard’s effective date.
• 84% preferred qualitative disclosures initially (2014, 2015), followed by quantitative disclosures in 2016.
• 67% said they preferred three years of comparative data and 21% expressed a preference for five years of comparative of data. Only 5% favored the prospective method.

Revenue Recognition and Measurement

At a high level, the IASB and FASB revenue recognition and measurement model can be described as a “five-step model.” The five interdependent steps include:

1)      Identify the contract

2)      Identify separate performance obligations

3)      Determine transaction price

4)      Allocate transaction price

5)      Satisfy performance obligation

Steps one through four identify the unit of account and the amount of revenue that is to be recognized. Step five defines when to recognize revenue, based on a transfer of control of goods, services, or licenses to customers.

A lot of the issued guidance involves mystifying new language with terms such as “performance obligations,” “contract assets,” “contract liabilities,” and “transfer of control to customers.” Notwithstanding the potentially daunting technical parlance, investors would be well served by paying attention to the implications of these five steps because they could significantly affect the amount, timing, and measurement reliability of reported revenue for certain business models.

For many businesses where cash is received at point of sale such as retailers, not much will change. Hence, when Peter walks to a retail outlet to buy a shirt and a pair of pants or buys lunch at a restaurant, there is unlikely to be any discernible change in the revenue recognition. For such business models, contracts are oral, there is minimal cash collection uncertainty, and revenue recognition is fairly straightforward because it occurs at point of sale.

Sectors That Will See Revenue Recognition Changes

However, the outlook is different for intellectual-property intensive industries with multiple product, license, and service deliverables in their customer contracts and with delivery spread across multiple periods. Software and biotech industries are good examples. The new standard will require the allocation of revenue on undelivered performance obligations (such as software upgrades), and allow the use of estimated selling prices when actual transaction prices are still undetermined. This differs from current requirements that require vendor-specific objective evidence for future deliverables. This change will affect the amount, timing, and measurement reliability of revenue.

Another area of likely change is in the variable consideration from the customer, or when the exact revenue amount due from the customer will only become clear at a future date. Variable consideration can occur when there’s potential for significant revenue adjustments at a future date (e.g., product returns). As an example, some manufacturers, such as those in the semi-conductor industry, rely on distributors to sell their products but face significant risk of product returns due to obsolescence. For such companies, the future-period product return volume and associated pricing uncertainties translate into variable revenue, and it will be critical for investors to monitor the cash conversion and the effectiveness of management in predicting future revenue. Another example of variable consideration discussed during the webcast was that of an asset management firm whose performance-based incentive fees are based on the level of the stock market index at a future date.

For long duration contracts (e.g., construction, real estate, engineering companies), the key question will be whether revenue will be recognized over time (as the customer good or service is being created) under methods similar to the well-known “percentage of completion” approach, or whether it needs to occur at a point in time. A webcast polling question showed that respondents were fairly evenly divided in their expectations around which of the steps, or management judgment, would most likely affect the businesses they follow:

• 24% said the variable-consideration measurement would have the greatest effect
• 22% said they expected criteria determining whether to recognize revenue over time to be significant
• 17% expected transaction price allocation for distinct performance obligations would have the largest impact

These findings most likely reflect the broad range of followers of business models and industries listening to our webcast. Interestingly, about one-quarter of the poll respondents (24%) said they were uncertain which steps would be most impactful, affirming the difficulty in anticipating the full effect of the new revenue model. It also points to the need for ongoing investor education on this crucial topic.

With its principles-based emphasis, the new standard will bring an increase in entity-specific management judgments, which could introduce potential information risk and underscores the importance of robust accompanying disclosures and the need for hawk-eyed tracking of revenue by investors in the run-up to the standard’s effective date.

In an upcoming blog post, I will further examine disclosures and cost-recognition requirements.

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Photo credit: iStockphoto.com/JDawnInk