As they file their first quarterly reports reflecting new revenue rules, companies may find their judgments will face a whole new round of scrutiny in the very next quarter.
The brand-new standard on revenue recognition took effect Jan. 1, so public companies are beginning to reflect the new accounting in their first quarter reports. The standard requires companies to follow a new, five-step method to determine when and in what amounts to recognize revenue in financial statements.
Relying more on principles than prescriptive rules, Accounting Standards Codification Top 606 requires companies to exercise a considerable number of judgments in determining how to comply. The idea behind that rule-making approach is to give companies more latitude to determine how their specific facts and circumstances should be considered and reflected in their reporting to investors. Ultimately, that’s expected to produce more consistent approaches to revenue recognition across capital markets, making results more comparable.
As those filings with their detailed disclosures finally become public, accounting leaders are expecting a scene to unfold not unlike school kids comparing math test scores—as in: “What did you get on number four? How come yours is right and mine is wrong?” Companies are widely expected to study one another’s disclosures to compare approaches, which may create some pressure to reconsider some of their judgments in subsequent periods.
Eric Knachel, senior consultation partner at Deloitte, is questioning whether inconsistent approaches to some of the judgments required under ASC 606 may have produced inconsistent approaches to revenue recognition, which could result in big differences in financial statement outcomes. As an example, one of the more challenging areas has been the determination companies must make about whether they are the principal party to a contract, or whether they are an agent acting as an intermediary between a seller and a buyer.
The distinction is important because it determines whether a company recognizes the top-line gross revenue amount or the net amount it earns directly as an agent in the arrangement, which represents a potentially huge difference in the amount of revenue that is recognized. “It’s a very sensitive issue,” he says. “It impacts the top line, and a lot of times metrics are based off of it.”
Knachel is thinking of companies that are resellers or distributors of various types of products, like computers, software, telecommunications equipment, pharmaceutical products, and medical equipment, among others. “The list goes on and on,” he says. In those kinds of scenarios, the conclusions have been based on some very detailed facts-and-circumstances analysis, he says.
“I think in certain industries, in certain types of arrangements, you will see companies entering into nearly identical arrangements, but you will see some diversity. Is the diversity justified? That is the crux of the issue. That is the real struggle companies are having.”
Eric Knachel, Senior Consulting Partner, Deloitte & Touche
“I think in certain industries, in certain types of arrangements, you will see companies entering into nearly identical arrangements, but you will see some diversity,” Knachel says. “Is the diversity justified? That is the crux of the issue. That is the real struggle companies are having.” Exercising the judgments required under the new standard has proven to be “maybe the single biggest challenge” of implementing the new accounting, he says.
The standard provides a framework within which those judgments must be made, so companies did not get a free pass to report whatever they want, says Adam Brown, a partner and national director of accounting at audit firm BDO USA. The Securities and Exchange Commission even reminded companies of that as they approached their year-end reporting.
“The SEC tried to establish a tone that reasonable judgments would be respected, but they also said that still requires a lot of work,” says Brown. “That’s the tension. Have they really demonstrated a thoughtful process to get to a reasonable judgment?”
As companies wrap up their first-quarter reporting, the analysis and debate will ensue. Analysts, investors, regulators, preparers, auditors, academics, and any others with an interest in the outcomes are going to compare results and scrutinize the reason for differences.
“Therein lies one of the big challenges of this standard,” says Knachel. “When is it OK to have different accounting treatments versus having different reasoned judgments? And when is it not OK?”
The Financial Accounting Standards Board and the accounting profession committed an enormous front-end effort to minimize such differences through the Transition Resource Group and the industry task forces at the American Institute of Certified Public Accountants, says Brown. Still, differences are possible. “It’s hard to say how prevalent that will be,” he says.
CFA Institute advice to investors on scrutinizing judgments
Investors should be mindful that the most interesting elements of the new standard may emerge as it evolves in the next several years because of the significant judgment and estimates the new standard allows companies to make and their potential effect on future earnings quality.
This new standard provides significant latitude in the use of judgments and estimates in the determination of performance obligations, the allocation of transaction price, and the timing of the recognition of revenue. Investors should confirm their assessments of earnings growth and risk as a part of the transition to the new standard. The effects of the new standard are not simply felt in the transition. The effect on the quality of earnings and the ability to manage earnings going forward are essential to understand and are an equally if not more important outcome when analyzing this transition.
The new standard has significant estimates and judgments related to the determination of what constitutes a performance obligation and how transaction price is allocated to such performance obligations, as well as the timing of satisfaction of the performance obligations (i.e., when revenue is recognized). Investors should seek insight into these judgments in evaluating the quality of earnings. We are concerned, however, that many of the disclosures will be highly qualitative and boilerplate.
Source: CFA Institute
Cullen Walsh, a partner at Grant Thornton, says some diversity may be explained by nuanced differences in contracts that lead to legitimate accounting differences. “There are substantive differences in contracts with customers that lead you to different conclusions,” he says.
Walsh also points out that even if diversity occurs due to variations in judgments, the new rules will still produce far less diversity than exists under historic accounting rules, which consist of hundreds of discrete pronouncements that often varied by industry sector.
“Today there’s a wide diversity in revenue because there are many common situations where there’s no guidance at all,” he says. Contract modifications, for example, and service arrangements are likely to get far more consistent treatment under new rules than under historic rules, he says.
And not all experts, however, are wringing their hands over the possibility of diversity in outcomes. Larry Smith, senior managing director at FTI Consulting and a former member of FASB who spent years helping develop the new standard, says differences in judgments are inherent with a standard built on principles rather than prescriptive requirements.
“Two well-meaning people when presented with similar fact patterns may very well come up with different conclusions,” he says. “It remains to be seen how accepting auditors and regulators will be in accepting those judgments. I don’t consider it a great concern.”
FASB was cognizant of the notion that companies would need to exercise a lot of judgment under a principles-based standard, which is what stakeholders in the standard-setting process seemed to be demanding, Smith said.
Another judgment challenge under the new standard focused on identifying performance obligations, says Patrick Durbin, a partner at PwC. It’s an important analysis because revenue is recognized only as individual obligations are satisfied. Where contracts contain multiple performance obligations, companies must identify them separately and allocate revenue to each individually, which stretches the recognition of revenue over time, sometimes many years.
“It’s not a brand-new concept, but the words used to describe it are new,” says Durbin. “The concepts can be abstract, and that has led to some challenges.” Different judgment outcomes can lead to very different patterns of recognition.
Durbin says he will not be surprised by some variations in reporting that will be scrutinized and adjusted in subsequent periods. “Inherently, there is probably that risk,” he says. “It’s going to be mostly up to the regulators to navigate that.”