Judgment Day for Revenue Recognition: You’ve Been Warned
Massive, looming changes in how companies must record revenue could mean higher reported profits for many firms in a couple of years—particularly those in the tech sector—but huge efforts will be required to implement the new rules and it could take years before public companies understand the full implications.
On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued the final rules, called Accounting Standards Update (ASU) 2014-09 (by the FASB) and IFRS 15 (by the IASB). The idea was to align more closely the U.S. standard of GAAP and the prevailing international standards of the IASB by creating a single, comprehensive model for accounting for revenue from contracts with customers.
That’s all well and good, but the new rules also have far-reaching ramifications for how companies conduct their day-to-day business, and that means many will have to evaluate and likely revamp everything from pricing strategies and sales processes, to how they distribute products, how they pay salespeople and even the technology they use to capture the data surrounding it all. The stakes are especially high for companies in the tech sector, which rely heavily on providing goods and services provided in contracts with customers that can stretch for years. While the new rules may accelerate revenue recognition at some companies, leading to higher profits and margins, pleasing CEOs and Wall Street investors, they may also increase the volatility of revenue and profits, which Wall Street won’t like.
The rules are complex and involve a variety of interpretations, but in a nutshell, recognizing revenue will involve five steps, beginning December 16, 2016, for public companies (private companies must adopt the rule after December 15, 2017):
- Identify the contract with the customer.
- Identify the company’s performance obligations under the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue as the obligations are satisfied.
Taking a look at just three notable aspects of the new rules offers a peek at just how much work companies may need to do to ready their people and processes for a new world of revenue recognition.
First is the collectability rule. Under the old rules, many tech companies typically record revenue from a contract over the life of a contract. But under the new rules, companies can recognize revenue under a customer contract now for payments it expects to receive from that customer later if it reasonably believes the customer will actually make the payments. The result is that companies can report some revenue earlier, boosting their bottom lines in the near term.
But as with all rules, there are caveats and unintended consequences, not the least of which is that company accountants must spend more time evaluating customer creditworthiness to determine the probability that the customer will pay over the course of a contract. In turn, some companies may avoid customers with poor credit, according to a PWC study.
Another notable aspect of the new rules is that for contracts in which a company expects payments from a customer more than a year later, companies can now record those payments when they transfer control of the good or service to the customer instead of recording those payments only when they’re eventually received. That can accelerate revenue recognition considerably, but it may also lead to accounting team members pulling their hair out, because now they have to come up with ways to estimate what those future amounts will be, guess at whether and how much of a discount or price concession the company will give the customer on that future undelivered good or service, and then calculate the present value of that payment. And if the company is charging customers an upfront fee, it now must record interest expense on the “financing” it is getting from the customer under the new rules.
A third example is the mound of work some accountants may need to do around the sale of virtual goods, which are an integral part of many “freemium” business models, particularly in the online gaming industry, where users can play a game for free but purchase virtual goods and services such as weapons, speed, or other characteristics. Under the new rules, companies must assess whether each virtual good represents a distinct “performance obligation” and then recognize revenue only when that obligation is satisfied, which could be a while. That means estimating the life of each virtual good, the length of time the user might use the service, and the life of the game. The problem is, there are billions of virtual goods out there, which means companies will have to develop a method for evaluating those purchases in bulk.
Those are just three examples; there are other aspects of the new rules that are just as challenging. How companies account for sales commissions associated with getting customer contracts is also changing, for instance, giving good reason to reevaluate incentive and bonus programs as well. Companies must now estimate the standalone selling prices of each good or service in their contracts too, and companies that sell through distributors can recognize more revenue now but may have to estimate sales and rebates to the distributors. And companies must now disclose much more about how they’re doing all the math.
These new rules demonstrate how much the accounting world is struggling to keep up with the business of technology. But the great irony is that in our digital world, when so many decisions can be reduced to an algorithm and automated, the process of calculating revenue has come to require more human judgment than ever. And for companies that aren’t prepared for the change, that judgment day may arrive sooner than they would like.
For more on Accounting Standards Update (ASU) 2014-09 (by the FASB) and IFRS 15 (by the IASB), visit: