In the Homestretch Until Top Line Changes Go into Effect, Investors Need to Be Alert
In “Watching the Top Line,” CFA Institute highlighted some of the anticipated effects and analytical implications of the updated US GAAP and IFRS revenue recognition requirements, which will become effective at the beginning of 2018. Although we are now in the homestretch prior to these requirements becoming mandatory, the question of what it will mean for companies’ revenue reporting patterns (amount, timing, and uncertainty) still remains, and investors who follow companies’ performance reporting have their work cut out.
Customer contract features (e.g., mix in goods, services, and licenses within contracts; contract terms; form and timing of payment to be received from customer; unexercised customer rights; financing arrangements; who controls the good, service, or license) could affect the amount, timing, and uncertainty of revenue for different businesses. Changes could occur in software, aerospace, engineering, construction, contract manufacturers, real estate, telecommunication, healthcare, variety of manufacturers, retailers, e-commerce firms, asset management firms, and other intellectual property intensive firms.
Despite the general understanding of likely impact in various sectors, it is hard to generalize the effects at a company level because there is much heterogeneity in business models used and profile of customer contracts among companies within and across sectors. Accordingly, many investors are likely to be still trying to figure out company-specific implications. This difficulty is exacerbated because (a) there have been very few early adopters of the revised standard, (b) many companies are yet to spell out whether there will be any material changes attributable to the revised requirements, (c) customer contracts are dynamic — for example, many businesses are switching to subscription models, and (d) there are generally poor revenue-related disclosures among companies. Revenue disclosures, including within the segment reporting sections, are usually barebone, boilerplate, and inconsistent.
Making Sense of It All: Helpful Standard Setter Resources
There has been a standing call for investor education on the effects of the standard. Over the past few months, the Financial Accounting Standards Board (FASB) has conducted two highly practical and investor targeted webcasts focused on the implications of the revised requirements and featured blue chip companies’ accounting experts from two sectors in which significant changes could occur.
The first webcast focused on the aerospace and defense sector, which is often characterized by complex and long duration construction contracts, and featured GE and Raytheon experts. The speakers made it clear that differences can exist between companies in the decision of whether to adopt early (Raytheon but not GE has adopted early), the choice of transition approaches (GE will apply the full retrospective method, whereas Raytheon applied the modified retrospective), and the materiality of effects (unlike for GE, Raytheon faced immaterial impacts). The speakers conveyed that both GE and Raytheon would mostly continue to recognize revenue over time for their long-term contracts in an analogous manner to the current “percentage of completion” method. Another point that came through was the need for investors to pay attention to “Day 1” transitional effects from the changes because there may be artificial lost revenue reflected directly through equity rather than through the income statement.
The second FASB webcast focused on the software industry and highlighted the necessary distinction in revenue reporting for software as a product sales (i.e., actual sale of software to customers) versus software as a service (SaaS) customer contracts (i.e., subscription, cloud computing businesses). The pricing structure of software as a product contracts includes upfront, point-in-time revenue attributable to software license installation fees (either term or perpetual licenses) and subsequent-period ratable (spread over time) revenue attributable to license maintenance, post contract services, and upgrade fees. In contrast, the SaaS business model (e.g., Salesforce, Workday) has mainly ratable revenue patterns.
The webcast featured panelists from IBM and Microsoft. Incidentally, Microsoft is one of the few companies that has chosen to adopt the standard early, and its management is anticipating significant effects. As reported in media outlets, Microsoft management has indicated that it will bill hardware makers for Windows 10 at the time of sale rather than through the life of the PC or hardware because the software is a distinct product. If the new approach had been applied in 2016, Microsoft’s revenue would have been $6 billion (7% higher) than was stated.
The webcast highlighted that in the software industry, changes in revenue patterns are mainly likely to arise for hybrid business models (i.e., a combination of traditional software as a product and SaaS) rather than for pure play firms.
A key message from both webcasts is that investors should keep in mind that regardless of changes that may occur in the timing of revenue, mere accounting changes that occur with no change in the underlying customer value proposition and/or economic profitability should not have any bearing on investors’ perception of performance and their assessment of the intrinsic value of any business.
The forthcoming changes have also drawn significant and ongoing media interest. MarketWatch has published several articles discussing the impact on different types of companies:
- “A New Revenue Rule Is Coming and Every Company Will Be Affected” — Covers the effects of varied aspects of the revised requirements on a wide range of companies
- “An Obscure Accounting Change Could Boost Amazon, Starbucks, Walmart Profits by Hundreds of Millions” — Highlights effects on a the widespread type of business model that sells gift cards
- “Banks Are Beginning to Admit That a New Rule on Revenue Recognition Will Have an Impact” — Shows that a general assumption that banks will be minimally affected is not so true
The perspective of CFA Institute on this topic has been featured in media, including a recent Accounting Today piece (“Investors Need to Watch for Revenue Recognition Changes”) and in an accounting web feature article (“Financial Analysis Implications of Revised Revenue Recipe”). Through our commentary, among other things, we have emphasized the need for investors to pay attention to contract cost recognition and gross margins, monitor transition reporting and related disclosures, and to scrutinize and carefully interpret disclosures, particularly those that relate to future revenue (the required disclosure is only a subset of backlog disclosures; this point was also raised in the earlier mentioned FASB webcasts).
In conclusion, I would say anecdotally that, at this stage, many companies tend to assert, if at all, that they will be minimally affected by the revised requirements. Yet, this portrayal that not much will change could lull investors into a false sense of comfort. As noted, top-level views of effects at the sector level cannot be extrapolated to the company level analysis, and companies themselves are often on a journey of discovery of the effects even when they do not own up to it.
It is not inconceivable that the complexity and multiple, significant judgments of the revised accounting changes could result in more far reaching and diverse impact than is anticipated. This possibility necessitates ongoing due diligence by investors so that they can appropriately interpret reported revenues and effectively monitor the performance and value creation of companies in their portfolio.
To contribute to investors ability to monitor companies’ revenue reporting, and building on earlier CFA Institute publications, in the next few weeks, we will be issuing a follow-up publication on the analytical implications of the revised requirements. Stay tuned.
If you liked this post, consider subscribing to Market Integrity Insights.
Photo Credit: ©Getty Images/vladwel