To understand the seismic shift about to take place in the way companies recognize revenue, investors would love to see three years’ worth of financial statement data presented under the new accounting method.
It is clear, however, that is not going to happen. A clear majority of companies are planning to use cumulative catchup adjustments and disclosures to bridge the gap from old to new accounting.
Public companies are nearing sprint pace to meet a year-end deadline to adopt a massive new accounting standard on how to recognize revenue in financial statements. Issued in 2014 and taking effect in 2018, the standard prescribes a new, five-step method all companies must follow to determine when and in what amounts to recognize revenue in financial statements.
Companies have two options for how to adopt the standard. They can elect a full retrospective method, which means they would apply the new method to not only their 2018 results as they roll out over the course of the year, but also to 2017 and 2016 results as if the rules had been in place all along. That would give investors a clear view of how revenue trends are affected from a historic standpoint.
“Trend analysis is very important,” says Vincent Papa, director of financial reporting policy at the CFA Institute, which represents certified financial analysts. “Having multiyear comparable data is the desirable endpoint for investors.”
“How are earnings releases and press releases going to help readers of financial statements understand their company now? Part of the discussion is helping reconcile what the trends were historically and going forward. Companies are starting to think long and hard about that.”
Derek Bradfield, Partner, Deloitte
When the Financial Accounting Standards Board adopted the standard, however, it recognized that may be a tall order given the enormity of the accounting change, so it also gave companies an alternative method. The modified retrospective approach would not require companies to restate historic figures, but would require them to make some cumulative adjustments to their opening 2018 balance sheets to reflect the new accounting method.
Companies electing the modified approach will also have to use plenty of disclosure to explain the differences between earlier and current results, but that’s still easier than going back into two complete years’ worth of transactions and applying the new accounting method.
MOTIVATION FOR UPDATING REVENUE RECOGNITION RULES
Below is an excerpt from the CFA Institute’s paper on investor scrutiny of the new revenue requirements.
Reported revenue amounts and growth trends are “top line” indicators of potential economic-value creation under any business model. Hence, revenue is arguably the most important and pervasive company performance metric because it is also the starting point for defining other key performance measures. For
example, revenue affects key income statement analytical ratios and related metrics (e.g., return on equity and return on assets) as well as balance sheet–based ratios that gauge asset utilization, solvency, and working capital management. In addition, for early stage growth companies, which typically experience negative profitability in their first few operating years, revenue rather than net income tends to be the key input for related valuation methodologies.
The pervasiveness of revenue as an input for valuation and bottom-line performance analysis probably explains the prevalence and seemingly unending high-profile episodes of egregious revenue misreporting scandals, from Enron Corporation and Xerox Corporation in the early 2000s to more recent episodes, such as Toshiba Corporation and Tesco PLC. These accounting failure episodes reveal a wide variety of revenue recognition misreporting practices. They also highlight how revenue misreporting can undermine the integrity and information efficiency of capital markets.
One area of misreporting occurs when a company inappropriately presents revenue on a gross instead of net basis. Groupon, an innovative internet-based retailer (e-tailer) whose business model entailed facilitating subscriber customer purchases and obtaining bulk purchase discounts from suppliers, exemplifies the incentives by early stage companies with less mature business models to overstate revenues premised on management anticipating favorable capital market valuations. From 2009 to 2011, Groupon inflated its reported revenues by presenting revenue on a gross basis rather than the more appropriate net basis. During that period, the company boasted of a seemingly astronomical revenue growth trend (from $14.5 million in 2009 to $1.6 billion in 2011) accompanied by strong stock price performance (Dutta, Caplan, and Marcinko 2014).
The US Securities and Exchange Commission (SEC) probed the appropriateness of Groupon’s accounting practices, which led to the company restating revenues on a net basis. A significant decline in the stock price followed. The Groupon case is similar to that of Priceline, another e-tailer that overstated revenue in the early 2000s via gross as opposed to net revenue presentation.
Apart from these company-specific revenue misreporting episodes, several other aggregate-level headline statistics point to the significant misstatement risk associated with revenue, including the following:
The 2016 International Forum of Independent Audit Regulators (IFIAR) report (IFIAR 2016) noted that revenue was one of four areas with the most auditor inspection findings.
A 2013 Center for Audit Quality study (Scholz 2014) reported that a significant proportion of restatements in the United States are related to revenue recognition—14% in a 10-year period.
A review of SEC Accounting and Auditing Enforcement Releases (AAER) from 1982 to 2005 revealed that revenue was the most frequently affected item, with alleged manipulations in 54% of 676 firms with misstatements (Dechow, Ge, Larson, and Sloan 2011).
The Financial Reporting Council (FRC) “Extended Auditor’s Reports: A Further Review of Experience” showed that auditor reports frequently identify revenue as a key risk area (FRC 2016).
The 2015 FRC Corporate Reporting Review Annual Report identified revenue as one of the top 10 areas with issues raised (FRC 2015).
Notwithstanding the importance of revenue and associated misreporting risk, both International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP) revenue recognition requirements are characterized by numerous deficiencies and complexities. For instance, in the United States, there are more than 200 pieces of revenue guidance literature and these are often industry specific and inconsistent. Investors thus have a difficult time analyzing companies’ financial statements across sectors because they have to learn the nuances of each sector’s revenue recognition model. The US GAAP guidance has been respectively defined by the FASB, SEC, and FASB’s Emerging Issues Task Force.
At the same time, under existing IFRS revenue recognition requirements defined in IAS 11: Construction Contracts and IAS 18: Revenue, there is incomplete guidance related to accounting for customer contracts with multiple deliverables. The result is that several IFRS reporting companies (e.g., software companies) have had to rely on US GAAP for reporting revenue.1 Concurrently, there are hardly any informative revenue-related disclosures provided across both US GAAP and IFRS reporting companies. These noted deficiencies, as well as the objective of creating globally comparable revenue, contributed to the FASB’s and IASB’s decision to undertake a joint revenue recognition project aimed at enhancing existing guidance. The resulting issuance of new US GAAP and IFRS standards, in FASB Accounting Standards Codification (ASC) 606 and IFRS 15, took place in May 2014.Source: CFA Institute
A mid-year review by Audit Analytics of corporate disclosures regarding transition to the new accounting requirement finds only 51 of nearly 500 in the analysis are planning to adopt the standard using the full retrospective approach. That suggests only about 10 percent of companies are applying the new accounting to both their 2016 and 2017 results so they will be presenting three years of results side by side.
That’s pretty consistent with what Derek Bradfield, a partner at Deloitte focused on the new revenue standard, is seeing in practice. Anecdotally, he believes roughly 80 percent to 90 percent of companies are electing the modified retrospective approach.
In many cases, that’s because they don’t see the new method driving big changes in the numbers they will report, so they don’t sense any trend analysis will suffer under the accounting change. “A good portion are in that bucket,” says Bradfield. “It just wouldn’t make that much of a difference from a comparative standpoint.”
Companies might also end up in the modified retrospective method if they delayed implementation and simply don’t have the time or resources to do all the restating of historic figures required under the full retrospective method, says Doug Reynolds, a partner at Grant Thornton. “If they hadn’t decided a while ago, they’re starting to run short on time to do a full recasting,” he says. “Some are saying it’s just too late now.”
Under the modified approach, companies need to gather up only contracts that are not yet fully satisfied when the company’s reporting year ends and determine how they would apply the new accounting to the remaining performance obligations under those contracts. They will calculate any differences between the old and new accounting approaches, adjust the opening balance sheet accordingly, and explain the differences in disclosures.
Ultimately, investors will deal with the lack of historic insight that might provide, but they’ll be asking plenty of questions and looking deep into the disclosures to get the trend analysis they’re looking for. “We do recognize in many cases we will not get to that ideal state,” says Papa. “Equipping investors with other information around how the business model may change will be important. What’s really important is having companies engaging with investors, giving them as much information as possible to understand the pattern of revenue recognition.”
Investors are particularly interested in understanding where revenue may hit the books sooner than it has historically, or where it may be delayed under the new rules, says Papa. Companies in high-tech sectors, like those that sell software, are expected to find they will accelerate the pace of revenue recognition under the new rules, which lift some of the constraints that existed under historic requirements.
Companies in telecommunications, on the other hand, may find that the unbundling of products and services under the new standard may lead to longer time lines over which revenue will be recognized. “It is certainly of interest to investors to know the amount, timing, and uncertainty of revenue recognition,” says Papa.
Investors will also want to understand how companies are recognizing costs associated with revenue recognition under the new standard. That’s an area of the standard that has led to plenty of questions in corporate accounting offices, and investors will have questions too. “Cost recognition has a bearing on margins, so that could influence how investors understand the economics of a business,” says Papa. There are aspects of the guidance that are “fairly judgment-intensive,” he says.
Disclosure will be a key area of interest for investors as well, says Papa. So far, investors have had concerns about the extent to which companies have explained the changes that are going to occur, an area the Securities and Exchange Commission has focused on extensively in recent months.
The SEC has promised it will be studying the transition disclosures, and Audit Analytics points out some companies are getting comment letters asking for more detail. “There’s an anticipation that disclosures should provide more transparency, particularly if companies are conforming to the spirit of the requirements rather than just taking a minimalist approach,” says Papa.
According to Bradfield, companies are starting to mobilize internally in terms of how their investor relations staff needs to prepare to communicate with investors. “How are earnings releases and press releases going to help readers of financial statements understand their company now?” he says. “Part of the discussion is helping reconcile what the trends were historically and going forward. Companies are starting to think long and hard about that.”