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The list of companies getting burned for improperly booking revenue is long, and has been getting longer ever since the SEC made revenue recognition a hot button enforcement issue in 1999.
And if you look closely, there is often a common denominator– subsidiaries.
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“Subsidiaries add a whole other layer of complexity,” says Mary Barth, Atholl McBean Professor of Accounting at Stanford University Graduate School of Business.
Although subsidiaries are held to the same generally accepted accounting principles (GAAP) as the parent company, methods for recognizing revenue can legitimately diverge if, for example, the subsidiary accounts for different types of revenue associated with different products or services. And because it is difficult for the CFO of a parent company to track and monitor revenue recognition practices at a subsidiary, underlings sometimes get a little creative.
“Subsidiaries have to follow GAAP just like the parent does, and it’s up to the parent to make sure that the kids are behaving,” says Jack Ciesielski, Publisher of The Analyst’s Accounting Observer, a R.G. Associates, Inc. publication.
But in the world of revenue recognition, things are never black or white, which makes parenting a lot more difficult.
Under SAB 101 issued in 1999, the SEC established four main criteria for proper revenue recognition: evidence that an arrangement between a buyer and a seller exists, delivery of a product or rendering of a service, a set or determinable price, and an assurance that payment can be collected.
Although these criteria seem straight-forward enough, revenue recognition is often a murky process, says Scott Martin, CEO of DiCarta, a contract automation software company.
Companies get into trouble, Martin stresses, when a subsidiary recognizes the same kind of revenue differently and does so too aggressively. Problems often arise, he says, when companies have multiple subsidiaries with similar types of products or services but different revenue recognition methods.
According to Martin and Ciesielski, the crux of the problem is that there is not enough top-level control over how the books at the subsidiary are managed. “There is a span of control that is not sufficiently high for those at the top level of the consolidating company to know what is going on in the field,” Ciesielski contends. “It’s a matter of being aware of what is going on in your roost.”
But Martin maintains that in practice, it is a huge challenge for CFOs at parent companies to keep an eye on revenue recognition practices at a subsidiary, in large part because they have very little insight and input into how the language in contracts at the subsidiary level actually gets translated into revenue schedules.
“Most companies get into trouble when they use a revenue recognition method that is in conflict with the intent of the original agreement,” he claims.
Control from the top is also impeded by the pain-staking nature of tracking revenue, Martin contends, which makes it difficult to get a consistent, bird’s eye view of revenue recognition practices at a subsidiary.
“It is largely a manual process, which is done one contract at a time. You start with the language in the contract and trace that back through to the general ledger,” he comments. “The further removed you are from the work, the less visibility you have into the decision process that was made. So by the time you are the CFO of the parent company, you could be screwed.”
Another obstacle to monitoring accounting practices at a subsidiary is that the internal audits that most parent company CFOs rely on to ensure that their offspring are not misbehaving, are ultimately statistical samples that do not analyze all of a subsidiary’s contracts.
“They may miss the issue and not see the trend because they are not looking at a broad enough sampling,” Martin comments.
He claims that CFOs at parent companies thus need a system that gives them greater visibility of contracts and how revenue is recognized from those contracts.
Contract automation software, he contends, might prove to be one such system of control. But because contract automation is an emerging software space, its practical benefits have yet to be seen.
Martin contends that software, which automatically tracks contract terms and conditions, and can issue checks to customers and suppliers when contracts are in force, can help CFOs monitor, for instance, whether revenue that should be spread over a four-month term is actually being recognized according to those terms.
According to Stanford’s Barth, “Software can give companies the ability to get their arms around what has become a spaghetti mess of idiosyncratic contracts. It can allow the appropriate levels of management to monitor what their underlings are committing the company to, and be in a position to step in before it’s too late.”
But companies have been monitoring their subsidiaries for years without the help of software.
Norman Strauss, national director of accounting standards at Ernst & Young, takes a more old-fashioned approach. He places much of the onus on the CFO at the parent company to foster an ethical culture from the top.
The top CFO, he says, is responsible for making it very clear that subsidiaries should under no circumstance cross the limits of proper revenue recognition, particularly during difficult times when pressures to meet budget are greatest. “The CFO should make it clear that no one should hide behind materiality; the best policy is not to try to get away with anything,” says Strauss.
The problem is, of course, that is much easier said than done.
