The improper recognition of revenue impairs the quality of reported financial statements, potentially misleading investors and regulators. The impact of revenue levels on the calculation and analysis of the financial statements – including margins, key ratios, and growth trends – causes revenue to be a highly manipulated and highly scrutinized data point. The SEC’s increasing scrutiny of high-risk areas, including revenue recognition, has led to the review of several high-profile companies. Both the IASB and the FASB have released updates on their converging revenue recognition standards that will take effect by 2018. The CFA Institute also recently published a whitepaper addressing some of the issues and concerns about revenue recognition and how they impact the issuers and users of financial statements.
Under current US GAAP and IFRS guidelines, the recognition of revenue is based on the probability of collection and the delivery status of promised goods and services. The newer standards allow revenue to be recognized over a period of time and is analogous to the percentage of completion approach more typically used for long-term contracts. Under the new standards, management will identify the separate performance obligations required by contracts, determine and allocate the transaction price across the contract components, and only recognize revenue as the contract obligations are fulfilled.
Key items to pay attention to include:
- Transition Requirements. The new GAAP standard will be effective on December 15, 2017 and the new IFRS standard will be effective on January 1, 2018. The standards allow preparers to apply the standard retroactively to their financial statements, to make the change in 2018 with a cumulative equity adjustment, or to combine the two methods and release a “practical” version of the retroactive adjustments. The adjustments under this third method can vary among preparers and will result in reduced comparability among companies until the transitions are complete. A poll conducted by the CFA Institute, IASB, and FASB indicated that users of financials statements prefer the retroactive presentation.
- Multiple Deliverables. Companies in some industries routinely enter into customer contracts with multiple deliverables. Examples offered by CFA Institute include software companies that provide regular updates of software and mobile phone contracts that allow for periodic upgrades of equipment. The new standards allow preparers to estimate selling prices if the actual pricing is undetermined and allows for revenue to be allocated to unfulfilled parts of the contract.
- Licenses. Licensing revenue can result from royalty payments on tradenames, technology, media copyrights (including music, photographs, and movies), and franchising. Under the current standards, licensing revenue could be recognized either over time or upfront. Under the new standards, the FASB offered guidance on when the over time or upfront methods of recognition are applicable by separating licenses into functional (the IP can process a transaction, perform a task, or be played, with revenue recognized at time of sale) and symbolic (everything that is not a functional license, with revenue recognized over time). A side-effect of the increased guidance could be the improvement of licensing disclosures in order for management to justify to investors the choice of revenue recognition.
- Gross Revenue vs. Net Revenue. Groupon and Priceline both drew the ire of the SEC due to their practice of reporting gross, rather than net, revenue. The updated standards emphasize the importance of the control of goods or services in reporting revenue and whether the firm categorizes itself as either principal or agent.
- Customer Credit Risk. Under existing guidance, companies use their own judgment to determine the likelihood of collecting revenue, allowing management to modify doubtful receivables in order to manipulate reported revenue. Under the new guidance, management needs to assess each contract separately and bad debt expense is excluded from the calculation of revenue. Investors will need to continue to be aware of contract write-downs and any changes in management’s basis for determining bad debt expense.
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