Investors Top-Line Watch: Navigating Long-Term Contracts Revenue Recognition Maze

In 2018, only 17 months from now, the revised guidance on revenue recognition from the International Accounting Standards Board (IASB) and US Financial Accounting Standards Board (FASB) — IFRS 15 and ASC Topic 606, respectively — will become effective. At this stage, investors and financial analysts should to be sharpening their focus on the likely and potentially significant changes in the amount and timing of recognized revenue and contract costs in business models that derive revenue from long-term customer contracts (e.g., engineering, aerospace, defense, infrastructure, and real estate development). These anticipated changes have analytical implications because they could, for these business models, affect profit margins, return on equity, and return on assets as well as such valuation metrics as revenue multiples and price-to-earnings ratios. It is not surprising that a recently published report by the European Financial Reporting Advisory Group (EFRAG) and Institute of Chartered Accountants of Scotland showed that a sample of European institutional investors considered revenue to be the most relevant performance measure for predicting future cash flows.

CFA Institute White Papers on Long Term Contracts Revenue

To help distill key analytical considerations, CFA Institute published the white paper “Top-Line Watch: Investor Considerations in Run-up to 2018 Long-Term Contracts,” which highlights areas within the revised guidance that could affect reporting outcomes for long-term contracts and thus need to be the focus of investors’ attention. These areas include criteria for recognizing revenue over time in a way similar to the current percentage-of-completion (POC) method, significant financing components, additional cost recognition and disclosures requirements, and transition considerations. That paper extends the analysis published in April in the white paper “Watching the Top Line: Areas for Investor Scrutiny on Revenue Recognition Changes,” which reviewed transition requirements, multiple deliverables within a contract, license revenue, gross versus net presentation of revenue, and customer credit risk. A follow-up paper to both of these papers will review uncertain revenue, contract definition issues (e.g., modification), and presentation of revenue-related lines on the financial statements.

Why it Matters

The need for the white papers is premised on the importance of revenue as a performance measure and analytical input as well as on it being an area that is prone to misreporting. Toshiba’s 2015 internal corporate governance review revealed that the company overstated its profits by $1.9 billion over a seven-year reporting period in large part because the POC method was misapplied in accounting for revenue from Toshiba’s infrastructure projects. Media coverage in 2015 reported that Boeing was allegedly under SEC investigation for potential misapplication of the program cost accounting method.

In a speech in May 2016, Wesley Bricker, who was SEC deputy chief accountant at the time and is now interim chief accountant, observed that revenue of S&P 500 Index companies (i.e., 90% of US market capitalization) amounts to a whopping $12.8 trillion. Because of its significance, changes in how revenue is reported requires an effective change management process that includes investors thinking about and companies communicating to investors the anticipated effects of the revised guidance.

The revised guidance requires multiple, complex management judgments in recognizing revenue from long-term customer contracts, which could make it daunting for investors to readily discern whether the timing of revenue recognition for companies that they follow will get accelerated, deferred, or remain the same. Hence, anticipated changes and effects of the revised guidance also should be a key part of conversations between investors and company management. It is important because as EFRAG noted in 2007,

Everybody knows what revenue is and when it arises. Or so it is often claimed. Yet on closer inspection, it becomes clear that, except in the simplest transactions, that is not actually the case.

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