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Financial executives say that proposed changes to revenue-recognition rules ignore real-world realities.
Marie Leone, CFO Magazine
October 1, 2010
What do TV sitcoms, cell phones, and construction sites have in common? At the moment, nothing. But a proposed rule change could create a thorny accounting challenge for companies as diverse as Time Warner, Apple, and Baker Concrete Construction.
The pending change to revenue-recognition rules would essentially create a one-size-fits-all approach, eliminating most, if not all, industry-specific applications and exceptions.
CFOs argue that the proposal isn't practical, introduces too much subjectivity, and imposes too great a burden while doing little to satisfy its ostensible goal of providing investors with more information.
"As a regional controller for a large, privately held concrete construction subcontractor…I don't [have] the luxury of breathing the rarefied air found only in the theoretical purity of regulatory boards. The construction industry is real-world [and] results-oriented," commented Allan Korsakov of Baker Concrete, in a letter filed with the Financial Accounting Standards Board in August.
FASB, of course, sees it differently. The draft rules, which are open for public comment until October 22, are part of a larger plan to find a happy medium between the surfeit of U.S. revenue-recognition rules and the dearth of international standards on the same. Currently, U.S. generally accepted accounting principles offer more than 100 pronouncements regarding when and how companies book revenue, including industry-specific rules for 25 different sectors, from construction to film production to software to casinos to airlines.
FASB argues that those voluminous rules create comparability problems for investors and other financial-statement users, because similar transactions are often treated differently and produce different results, even for seemingly similar companies. At the other extreme, international financial reporting standards contain just two broad revenue rules augmented by four interpretations; as a result, some IFRS users complain about imprecision if not outright confusion regarding which overriding principle should be applied.
The goal is to meet in the middle by the second quarter of next year via a "converged" standard. From that perspective, the revenue-rule project "is probably one of the more practical changes I've seen come out of standards-setting bodies in a long time," says Ed Hackert, audit partner at accounting firm Marcum LLP. Despite the inevitable anxiety that any major accounting change inspires, Hackert says that "once you peel back the onion, understand how it works, and begin applying it, you gain an appreciation of its practicality."
Some companies got a taste of the new rules before the exposure draft was issued. In January, Apple announced it would early-adopt FASB's Emerging Issues Task Force (EITF) guidance in the first quarter of fiscal 2010, on a retrospective basis, and provided comparable financial results for its last three fiscal years as if the new rules had been in effect.
By adopting the guidance, which is similar to the rules laid out in the exposure draft, Apple accelerated the recognition of revenue for such popular products as the iPhone and MacBook, giving a boost not only to revenues but to profits as well. As it turned out, the quarter was Apple's best ever.
But not all preparers are ready to embrace the proposed changes. Most of the more than 200 comment letters filed in response to a December 2008 discussion paper issued ahead of the exposure draft supported the idea of creating a single source of concise, meaningful standards, but criticized many of the details prescribed by FASB and its overseas counterpart, the International Accounting Standards Board.
In the exposure draft, FASB and the IASB acknowledge that the proposal may cause temporary upheaval, especially with respect to the required "retrospective application" of the rules. They also acknowledge that the rule revisions will be especially hard on companies with long-term contracts, and for those that find it difficult to estimate stand-alone selling prices at a contract's inception. To alleviate some of the transition pain, the boards may limit retrospective application if it is impractical, and provide a long lead time before the new standards take effect.
Companies are likely to need the breathing room to retool processes and systems to comply. One of the more significant changes proposed is the way revenue from exclusive licensing agreements is recognized. Under the draft rule, revenue is booked over the life of the contract, instead of up front, when the licensed items are available for use, says Allan Cohen, assistant controller at Time Warner and chair of the financial-reporting committee of the Institute of Management Accountants, a trade group.
That means that when Time Warner and other media and entertainment companies license exclusive syndication rights to television shows, recognition of the contract revenue must be spread over the life of those multiyear agreements. "That's a pretty significant change," asserts Cohen, referring to the shift related to when revenue hits the income statement, and a host of new required disclosures surrounding the contract elements.
Not Ready to Roll Forward
The draft rule contains four pages of new disclosure requirements, which include an explanation of changes in contract asset and liability balances from period to period. That means that if a contract is in an asset position, "you have to roll forward your balance-sheet accounts" and show the results in tabular form, explains Cohen. The table includes beginning balances, revenue from performance obligations and transaction price changes, and other adjustments that reconcile the ending contract asset balance — all data that Time Warner has, but is not ready to roll forward in the prescribed manner until its accounting systems are reconfigured.
The draft also requires companies to reveal their "onerous performance obligations" — contracts that lose money and therefore require companies to disclose how transaction prices are allocated to various performance obligations cited in customer contracts.
One of the more contentious allocation issues involves contract options; the proposed rules consider a license-renewal option a discrete element of a contract to which a value must be ascribed, which may take more-subjective judgment on the part of preparers. "Frankly, I am not sure how to value that type of option, because it is never sold separately from the contract," Cohen says.
Similarly, the draft rules tackle the controversial issue of assigning a fair value to bundled products, by incorporating the latest revenue-recognition guidance from the EITF into the proposal. Specifically, contracts that don't fall within a higher level of accounting literature — such as percentage-of-completion accounting — are required to use the new EITF methodology on so-called multi-element arrangements.
Like the license-renewal options, the sticking point for bundled products under the draft rules is that each element in a bundle — like an iPhone or a biotech or construction contract that features multiple milestone payments — must be ascribed a value. But such items are rarely, if ever, decoupled from their bundles and sold separately, so determining a selling price is complicated and costly.
In the case of Apple, the bump in quarterly revenue was worth the effort, according to Marcum's Hackert, who points out that when there is a significant difference between the estimated fair value of an element and the selling price, the new methodology can provide a material boost to the income statement. But for goods and services priced more like commodities, such as those in the low-margin retail sector, there generally won't be much revenue recognition to accelerate.
Given that, most companies would like to put the brakes on the new rules. The remaining weeks of the comment period, therefore, offer an opportunity to speak up — one that companies should surely recognize.
Marie Leone is senior editor for accounting at CFO.
Pending changes to current revenue-recognition rules will affect dozens of industries, all of which have until October 22 to comment on them. None seem likely, however, to match the collective agitation of the construction industry, as evidenced by the following comments.
"The new standard will require construction companies to keep two sets of books, one for GAAP purposes and one for management and the bonding companies…. The monthly financials under GAAP would be meaningless, as significant swings in revenue would happen without any significant change in the construction of a project."
— Mark Wheelis, CFO, Pogue Construction
"I believe the exposure draft is entering dangerous waters and is changing a system that has proven to work well for contractors, financial institutions, and surety partners. [The rule known as] SOP 81-1 can be improved, but making such a drastic change…leaves too much subjectivity and will increase costs for what is already a traditionally low-margin area of our economy."
— Valerie Lind, CFO, Yearout Mechanical
"Not only would this change paint a very different picture of the progress on a project, [but] any deviation from the IRS-sanctioned percentage-of-completion method of revenue recognition will create additional complications in reconciling the two methods…[in addition] we have no idea…if the changes you are proposing can be handled by our existing software."
— Allan Korsakov, Regional Controller, Baker Concrete Construction
Companies may run into major complications when their accounting systems try to handle the new fair-value allocation models, says Kelley Wall, a senior consultant with RoseRyan, a finance and accounting consultancy. The problem is that most enterprise-resource-planning (ERP) systems are programmed to handle the more popular residual allocation method, which assigns a straight dollar amount of revenue to each element of a bundled product. Under the new rules, companies will have to use the relative selling price method, which allocates revenue for bundled products based on a percentage. Generally, only ERP systems built specifically for software revenue recognition are configured to handle the percentage method. As a result, the proposed rules will force companies to either tweak their ERP programming or find a work-around solution.
ERP vendors, including SAP and Oracle, say that adjusting systems to accommodate new accounting rules is par for the course. But neither vendor is able to comment on the extent to which customers will be affected until the new rules are finalized. Meanwhile, some software vendors, including NetSuite, are offering service-based fixes. That is, companies can send their transaction information to NetSuite and the vendor will crunch the data using the relative selling price method and send back journal-entry-level answers. — M.L.