CFA Institute recently published Revenue Recognition Changes: Key Judgments and Implementation Progress, which reviews the reported results of several early adopters of the revised revenue recognition standard (Accounting Standards Codification Topic 606) that becomes effective at the beginning of 2018. Early adopters include Microsoft, Alphabet, Raytheon, Ford Motor Company, and General Dynamics. In several cases, the early adopters bring to the fore the effects on the amount, timing, and presentation of revenue attributable to key judgments in the new requirements. Insight can also be drawn from the disclosure of impact by a few soon-to-adopt companies, such as British engine manufacturer Rolls-Royce. That said, investors and other readers of financial statements are by and large still faced with the challenge of discerning the effects and implications of these key changes to revenue reporting because of the fairly limited reporting, at an aggregate level, of either the realized or anticipated impacts of the new revenue recognition requirements.

Transition Reporting Unlikely to Aid Trend Analysis

The ability for investors to discern the impact of the changes on year-to-year revenue trends is not helped by the fact that many companies seem to be choosing the modified rather than the fully retrospective transition method. The allowance for companies to apply practical expedients (i.e., exceptions to general requirements) through the modified retrospective approach could effectively lead to multiple and incomparable transition reporting approaches.

Limited Disclosures by Soon-to-Adopt Companies

Although very few companies have early adopted the revised requirements, it would have helped investors if the large universe of soon-to-adopt companies adequately communicated about the effects of the changes. Most companies are mainly providing fairly high-level and  qualitative disclosures of the impacts, and they often justify the limited disclosure with the assertion that the effects of the revised requirements are either immaterial on an ongoing basis or immaterial at an aggregated or net basis (i.e., limited impact on equity or on net income). But such a portrayal of the changes being no big deal could simply reflect that several companies are yet to fully unpack the consequences of the changes, or alternatively, the claims of immateriality might be misleading. For example, changes deemed to be immaterial on a net basis could be significant on individual line items (i.e., significant changes in gross revenue, contract costs, deferred revenue).

Analyzing and Reviewing Key Judgments

The new white paper offers further analysis of critical judgments that could affect the amount, timing, and estimation error of revenue and builds on past CFA Institute commentary on the subject: Watching the “Top Line” and Top-Line Watch: Investor Considerations in the Run-Up to 2018. In addition to earlier commentary, the white paper presents reviews of judgments pertaining to sales with rights of return, gift card breakage, contract combinations, and modifications.

Incidentally, sales with right of return is one of the revenue topics frequently reviewed in recent SEC comment letters. Sales with right of return (e.g., consignment sales) are susceptible to real earnings management via channel stuffing, which is the practice of shipping more goods to distributors and retailers along the distribution channel than end users are likely to buy in a reasonable time period. Channel stuffing is usually achieved by offering lucrative incentives, including deep discounts, rebates, and extended payment terms, to persuade distributors and retailers to buy quantities in excess of their needs. Additionally, gift cards have become pervasive across business models (e.g., most retailers issue these) and associated revenue recognition issues could affect revenue timing. Gift card breakage income (i.e., unredeemed gift cards) had grown to US$1 billion by end of 2016 (According to Gartner Research), and the revised requirements could expedite the recognition of breakage income.

Summary

The effects of critical judgments have begun to crystallize in the reporting by a few companies. Yet there is a relative paucity of information on the impact across the universe of reporting. Hence, there will remain a need for a continued push by investors for robust company disclosures on the effects of these key changes in the run up to and after the adoption of the revised requirements.

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