Revenue Recognition: Will a Single Model Fly?

Elements unique to long-term contracts pose a challenge for FASB and IASB in their bid to create one standard covering all customer relationships.
David McCannJuly 2, 2009

Can U.S. and international accounting standard-setters realize their dream of fashioning a single revenue-recognition standard that would apply to all customer contracts? While the answer won’t be known for some time, it’s safe to say there are hurdles on the road ahead.

In a joint discussion paper issued last December in which the Financial Accounting Standards Board and the International Accounting Standards Board proposed a model for a lone standard, they acknowledged that an alternative approach could be needed for some contracts. The almost 200 letters they received in a comment period that ended June 19 did nothing to remove any doubts about whether having one standard will be viable.

Most of the letters agreed that the standards boards’ goals are laudable. One main objective is to simplify and clarify FASB’s revenue-recognition rules, which currently are scattered among more than 100 standards. Another is to offer more guidance than what’s contained in IASB’s broadly worded revenue-recognition principle.

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In meeting those twin objectives, the boards would be advancing their overarching goal of converging U.S. and international standards. The major goals aside, however, many commenters registered alarm at specifics of the proposed model — especially concerning how revenue should be recognized under long-term contracts.

Today, entities typically recognize revenue when it’s realized or realizable and the “earnings process” is substantially complete. The new model instead would direct the entity to record the gain when it performs an obligation under its contract, such as by delivering a promised good or service to the customer. (The contract need not be written; even a simple retail transaction involves an implicit contract in which the customer agrees to provide consideration in return for an item.)

In a simple example, if the entity had agreed to provide two products at different times, it would recognize revenue twice, even if the contract stipulated that payment would not be made until the second product was delivered. The discussion paper mentions several permissible bases on which revenue could be allocated to the different performance obligations. But the paper says the revenue should be in proportion to the stand-alone selling price of the good or service underlying a performance obligation. And for an item that’s not sold separately, a stand-alone price should be estimated — something that the standards boards acknowledged could be hard to do.

A main purpose of the performance-obligation approach is to iron out many of the disparities in how businesses account for revenue, which the boards say make financial statements less useful than they should be. The discussion paper gave the example of cable television providers, which under FAS 51 account for connecting customers to the cable network and providing the cable signal over the subscription period as separate earnings processes. By contrast, under the Securities and Exchange Commission’s SAB 104, telephone companies account for up-front activation fees and monthly fees for phone usage as part of the same earnings process.

“The fact that entities apply the earnings process approach differently to economically similar transactions calls into question the usefulness of that approach [and] reduces the comparability of revenue across entities and industries,” the discussion paper stated.

Long Engagements

Perhaps the thorniest issue arising from the standards boards’ proposal involves long-term construction or production contracts. Historically, under many such arrangements the company recognizes revenue using the “percentage-of-completion” method — if it’s a three-year project with costs of $3 million, and $1 million of that is expended in the first year, one-third of the revenue is reflected for that year.

The single-model proposal, on the other hand, says that revenue should be recognized as an entity “transfers control” of goods and services to the customer. But many comment letters noted that the discussion paper did not clearly define what constitutes a transfer of control.

A company that is constructing a building for a customer may regard the materials and labor being provided as a continuous transfer of goods and services, which under the proposed model could be construed as allowing them to continue to recognize revenue over the duration of the contract. But if the standard setters hold that “transfer of control” occurs when the building is completed and turned over to the customer, all of the revenue would have to be recognized in the final year of the contract.

Lynne Triplett, a partner and revenue-recognition expert at Grant Thornton, told that the way the discussion paper is written, “There could be questions as to whether there is continuous transfer of control, and to the extent there’s not, there is going to be a significant difference between the way revenue is recognized today versus how it might be recognized in the future.”

That would create misleading financial statements, according to some of the comment letters. “The most concerning area of the discussion paper is the potential change to the accounting for long-term contracts,” wrote Financial Executives International Canada. “Creating a model which results in ‘lumpy’ revenue recognition … with a waterfall effect in one accounting period at the very end, is not useful to the readers of financial statements.”

The defense contractor Raytheon wrote that accounting for performance obligations separately when goods or services are delivered at different times is impractical for highly customized and complex engineering, design, and manufacturing services. “Assigning value to portions of the arrangement is not meaningful, as each contract is unique and therefore each component of a contract is unique,” Raytheon said in its comment letter.

It also claimed that the likely result will be inconsistent identification of performance obligations from company to company, “which is counter to one of the primary objectives” of the standards boards’ revenue-recognition project.

Those comments may resonate with the standards boards. FASB’s revenue-recognition project manager, Kenneth Bement, told that Raytheon’s arguments are “good stuff” and worthy of debate.

Another defense contractor, General Dynamics, urged the standards boards “to consider reducing the current revenue recognition framework to two or three models rather than just one, including a separate model for the long-term contracting environment.”

Whether to expand beyond a single model “is certainly something we’re interested in feedback on,” Bement said. “Some board members, even though they support the model in the discussion paper, think the model works great for most contracts but not all.”

Indeed, in addition to long-term construction projects, the discussion paper noted that consideration may be given as to whether the model will be viable for: recognizing revenue from long-term, fixed-price contracts for goods and services with volatile prices; contracts in which the outcome depends on specified uncertain future events; some derivative contracts; and some insurance contracts.

Bement also agreed that certain key concepts need sharper definition and more guidance. “The boards will have to decide what ‘control’ is and what ‘transfer’ is,” he said. “The model is not complete, and even the parts that are complete are still just high-level principles and not the way a standard would be written.”

But some of the commenters evidently didn’t understand that, he suggested. “I think a lot of the criticism is coming from people who perhaps were expecting an exposure draft rather than a discussion paper and perhaps don’t appreciate the level at which discussion papers are written.”

Further, although “control” needs to be defined better, Bement said a number of commenters mistakenly assumed that the word refers to physical control or taking legal title. “What we’re talking about is accounting ownership, which is not necessarily the same thing,” he said.

FASB and IASB will next deliberate further steps on the project at a joint meeting on July 23 in London. Bement could not say when the boards might be ready to issue an exposure draft.

Telephone Troubles

Meanwhile, there are potential issues with long-term contracts other than those involving construction. Verizon, for example, wrote that attempting to recognize revenue according to the obligations of its customer contracts not only would be impracticable, it would materially affect its financial results.

The telecommunications company pointed to its customer base of almost 100 million, a large number of which are under contracts that include many combinations of billable items — equipment, activation, basic monthly service, texting, Internet access, data downloads, and many others.

“The information required to prepare accurate accounting entries [as contemplated in the discussion paper] would require changes to point-of-sale and billing systems, as well as related accounting and reporting systems, including the general ledger and a separate data warehouse,” Verizon wrote.

Bement said Verizon’s comments “are consistent with what we’ve been hearing from that whole industry.” While he couldn’t speak to the system changes that would arise from adopting a new revenue-recognition model, he added, “My view is that recognizing revenue as they bill their monthly services makes a lot of sense.”

And Dell, the computer giant, noted that under software contracts, control or title generally does not transfer to the customer at all, but rather the customer has a contractual “right to use” the software. “The final model will need to carefully consider how software transactions and the elements of post contract customer support and upgrade rights will apply in the new model,” Dell wrote in its comment letter.

Bement said, “That’s a good one. I think the board needs to think more about it, about when the prima facie is intangible by nature. When does the customer receive these rights to use? Is it all at once? Over time? Does it depend, and if so, on what?”

The Survey Says

Most comments to initiatives by standards bodies and regulators take issue with something being proposed. However, there appears to be a fair amount of support for what FASB and IASB are trying to do with revenue recognition.

In an April survey by — a website sponsored by Softrax Corp., a provider of revenue-management software — 54% of 515 finance executives agreed that the contract-based approach outlined in the discussion paper would clarify the earnings process. Only 29% disagreed.

However, the level of resistance to a contract-based approach increased as the number of revenue arrangements offered increased. Respondents with seven or more different types of such arrangements were twice as likely to disagree with the approach as those with three or fewer.

In addition, 71% of survey participants agreed that the boards’ proposed definition of a performance obligation would help entities to identify the deliverables in (or components of) a contract more consistently.

But were their responses well-informed? Only 8% said they had a detailed understanding of the discussion paper, while 48% said either that they had taken a cursory look or had no prior knowledge of it before taking the survey.