In the grittiest work to adopt the new revenue recognition standard, accounting experts at companies and accounting firms are engaging in sometimes heated discussions over how to interpret the new requirements and apply them to today’s most complex business transactions.
The new accounting standard governing when and in what amounts to recognize revenue takes effect in 2018 for public companies reporting under U.S. GAAP, turning over the apple cart on how companies have adapted, one at a time, to hundreds of historical accounting pronouncements over decades. Under the new five-step model—in which companies must identify their contracts with customers, identify their performance obligations under the contract, identify the transaction price, then allocate that price to the separate performance obligations—the exercise is perhaps nowhere more complex than in the telecommunication sector.
Have you bought a cell phone lately? Consumers rarely pay the retail cost of the phone upfront. It’s bundled with a service package with payments spread over time, including a veritable banquet of options for how much data and at what speed, how much talk and text, software upgrades, customer support, not to mention activation, renewal, and cancellation provisions.
Separately identifying all those performance obligations is proving to be a bit like separately identifying the ingredients in a freshly baked loaf of bread. Attaching a transaction price to each is even trickier. Companies in that line of business don’t sell data separate from talk time separate from upgrades or customer support, so there’s no objective evidence of how that pricing should look under the new rules.
Bill Schneider, director of accounting at AT&T and a member of the telecommunications task force at the American Institute of Certified Public Accountants, says there are still many difficult issues for companies with complex business transactions to sort out. “From a technical accounting perspective, the difficulties arise under all five steps of the new standard,” he says. The software task force is one of more than a dozen the AICPA is operating to try to work through industry-specific challenges.
“The new rules will highlight the different approaches companies are taking in their business operations and the way they deal with their retailer network. All of those things will affect how you recognize revenue. If you have differences in how companies go about these things, it will show in the financial results.”
Bill Schneider, Director of Accounting, AT&T
In the wireless industry, customers move in and out of contracts and modify their contracts frequently, says Schneider. They change service levels, they trade in devices and upgrade plans, and in cable arrangements they change channel packages often. The sector is highly competitive, extending new offers regularly to win new customers or new revenue from existing customers.
One of the most contentious issues, says Schneider, is sorting out how to account for equipment installment plans. The new standard is not crystal clear on when companies need to account for a financing component to installment plans. That is leading to heated debates over whether companies should recognize revenue either upfront at a point in time or spread out over a period of time, depending on the circumstances.
“It’s a judgment call, ultimately,” says Schneider. “You can have two rational people looking at the same transaction and coming up with different answers. And they could both be right under the standard.”
Given that very real possibility, it is likely to lead to much more attention to how different companies in a given sector operate, in Schneider’s view. “The new rules will highlight the different approaches companies are taking in their business operations and the way they deal with their retailer network,” he says. “All of those things will affect how you recognize revenue. If you have differences in how companies go about these things, it will show in the financial results.”
While many accounting experts consider telecommunications to be the industry sector wrestling the biggest accounting issues like these, companies in software are considered a close second. “It’s the intangible nature of what we sell,” says Christoph Hütten, chief accounting officer at SAP, a business operations software company. “If you buy a car, it’s difficult for the vendor to tell you that some things don’t work yet, but we’ll update that later and then you will have a perfect car.”
And for companies like SAP reporting under both International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) depending on the jurisdiction, the complexity is even greater. SAP has designed many of its accounting policies so they would be applicable under both GAAP and IFRS, says Hütten. The company’s current accounting policies book for revenue recognition alone is more than 600 pages.
IDENTIFYING A CONTRACT WITH A CUSTOMER/OVERVIEW
Below is an excerpt from KPMG guidance on revenue in consideration of contracts.
A contract with a customer exists under the new standard when the contract is legally enforceable and certain criteria, including collectibility, are met. However, the collectibility threshold at inception will usually be met for telecom consumer contracts.
The more complex issue for telecom entities is determining the contract duration. Although telecom contracts often have a stated term, sometimes the stated term may not be enforceable. In other cases, the term may be implied. In each contract, assessing the contract term is key to determining the contract’s transaction price, which, in turn, significantly affects the allocation of that transaction price and therefore the recognition of revenue for each performance obligation (e.g. service and equipment in a bundled arrangement).
Contracts entered into at or near the same time with the same customer (or a related party of the customer) are combined and treated as a single contract when certain criteria are met. Combining telecom contracts results in a single total transaction price that is allocated to all performance obligations in the combined contract.
A contract with a customer is in the scope of the new standard when it is legally enforceable and it meets all of the following criteria.
“We have more accounting policies in SAP for revenue than for all other accounting topics,” he says. “If you’re changing the rules of the game, that’s 600 to 700 pages of guidance, 600 to 700 pages of policies.” Heap the content change onto the business change management and resulting training that must take place, and it demonstrates the scope of the undertaking.
SAP is still working through the diagnostics to determine how the new standard will affect the company’s overall pattern of revenue recognition. “There will be differences in different directions,” says Hütten. “Some contracts will result in revenue earlier, some later.”
Eric Knachel, senior consultation partner at Deloitte, says software and technology companies in general are working through some major challenge areas in terms of determining how to apply the new rules to their contracts. Identifying performance obligations is one of them. Software companies like to say they are selling solutions, not exclusively products or exclusively services. “It’s a mix of products and services that are interrelated to various degrees,” he says.
So it’s more like the loaf of bread than a collection of flour, yeast, and oil, not to mention the service of baking them into a ready-to-consume end product. Companies in the technology sector are likely to combine performance obligations in the course of recognizing revenue, he says. “I would not say it would be uncommon to combine,” he says. “I wouldn’t say it will be frequent, but it’s not something that’s going to be rare.”
Even further, Knachel says he hears companies engaging in discussion of whether the new standard might inspire them to change the way they go to market in certain instances. Existing rules for revenue recognition include some constraints that make revenue recognition highly conservative. Those constraints are lifted under the more principles-based standard, he says.
“Many companies felt handcuffed by the pricing rules,” says Knachel. “The new standard eliminates rules that by many were considered to restrict pricing flexibility, so with the new standard companies will likely exercise much more latitude in their pricing policies.”
Hütten says it's too soon to say if or when such business practices might change under the new standard. “It would be a step in the dark,” he says.
KPMG recently published a revenue recognition guide specifically for telecommunications companies to address the many questions that are still swirling around how to adopt the new standard, and it’s nearly 200 pages long. Questions are still “sometimes quite hotly” discussed and debated, it says.
Prabhakar (PK) Kalavacherla, a partner at KPMG, says he’s getting nervous about the state of readiness across public companies for the new standard. He cites a recent KPMG survey that revealed many companies are stuck in their implementations in the assessment phase. “The bigger companies will get it done because they have the resources to do it,” he says. “I am personally worried whether smaller companies will scramble to the finish line.”