The first rule of care and feeding of directors and CEOs is “no surprises.” A major one is lurking in the new revenue recognition rules adopted by the United States and Europe, due to be implemented in 2017.
While the accounting world is abuzz with news about the pending changes to the rules for revenue recognition, and the profound effect they could have well beyond the corporate accounting department, the rest of us are asleep.
That could be a huge problem. Revenue is such a fundamental building block that the rule change will affect everything from executive compensation to fraud prevention to internal controls to the cost of the external audit to how—and how much—markets value companies. Simply put, the rules change everything. And not enough people are paying attention.
The good news is that most financial officers seem to be at least somewhat familiar with the new standards. According to a recent PwC survey for the Financial Executives Research Foundation, only about 16 percent of finance professionals have not yet considered the effect of the new rules, even though they don’t take effect for most companies for another two years.
The bad news, however, is that more than 80 percent of directors either haven’t even begun to consider the new rules or have only “somewhat” considered them. Amongst audit committee members, the number isn’t much better: 74 percent have not thought about the issue or have done so only cursorily. Indeed, the PwC/FERF report estimates that only about 5 percent of directors, whether or not they are on the audit committee, have significantly considered how the revenue recognition rules will affect their companies.
What’s the big deal, you might ask? The rules (designed to replace myriad inconsistent, industry-specific do’s and don’ts with a more coherent set of underlying principles and objectives) won’t take effect until reporting periods after Dec. 15, 2016. That’s nearly two years from now.
But directors are paid to look ahead. The adoption time frame is already colliding with some fundamental boardroom decisions, such as the shape of executive compensation programs and strategic plans, both of which are based on multi-year horizons.
Revenue is such a fundamental building block that the rule change will affect everything from executive compensation to fraud prevention to internal controls to the cost of the external audit to how—and how much—markets value companies. Simply put, the rules change everything. And not enough people are paying attention.
For example, the performance metrics for long-term executive compensation plans generally cover a three-year time period. That means compensation committees are deciding on long-term incentive plans now without being aware that the way those metrics are calculated will change midway through the performance period. The results may surprise your CEO and your board … and that generally is not a good thing.
Similarly, a recent McKinsey study notes that most directors believe a strategic planning period should span four years or more. Though many companies don’t meet that standard and use only two, many do have three- or four-year plans. Will the changing patterns of revenue recognition affect those plans? The truth is that most boards just don’t know.
The point is that the changes to how revenue is recognized will have multiple spill-over effects, from executive compensation to calculating debt coverage ratios.
So what should you do?
First, be sure your finance department is familiar not only with the new revenue recognition rule and guidance, but also with how it will affect your company—and it almost certainly will affect your company somehow. Will the effects be material? Good question. While only 17 percent of the respondents to the PwC survey said they expect the new guidance to cause material changes to the income or balance statements, 23 percent admitted they didn’t know, and a whopping 41 percent didn’t answer the question.
Second, understand that an unlikely entity—the general counsel’s office—may have the key to understanding, and potentially determining, if revenue recognition is likely to be accelerated or delayed. The reason is that while new guidance eliminates specific revenue recognition rules and replaces them with judgment, that judgment has to be based on certain events and conditions, such as contract terms that spell out when “control” is transferred. If you have contracts that are long-term, multiparty, include variable consideration (such as volume discounts or rebates), or sell software or other licensed products, there are more wrinkles.
In almost all those cases, the starting point for your exercise of judgment is for the contracts to state explicitly what the performance obligation is, and what will satisfy transfer of control. So make sure your finance department coordinates with your counsel’s office to understand what’s likely to happen and, if necessary, to try to revise contracts as needed.
Third, create an intra-company working group to study the potential effect of the revenue recognition rules, and have them start working immediately. We strongly suggest it include the counsel’s office for the reason above.
Make sure that working group casts a wide net and looks at all functional areas, with an eye to any metrics that include revenue. For example, internal controls may need to be harmonized to the new rules. The changes may affect some companies in areas as widespread as financing (will it affect your loan agreement coverage ratios?) to customer service (do volume discounts or return policies change revenue recognition patterns?). If the changes will be material enough, you might want to bring in your investor relations department, so that it can start preparing your shareowner base.
Although only a few companies told PWC that they anticipate actually changing fundamental business practices as a result of the new rules, explaining the likely effects in advance to your shareowners and the analyst community can only be a good thing.
Once the plan is in place, be sure to figure out the best way to brief the board. Focus on what the directors need to know about the specific effects on your company, and on how the revenue recognition changes may affect board-specific responsibilities, such as changes to financial statements and executive compensation.
As a follow-up, provide a periodic progress report to the board or audit committee, up to and through adoption. After all, you’ll all be living with this project for a long time.