With the accounting for revenues seemingly set to undergo a sea-change, CFOs will likely soon have a heads-down focus on the ways companies calculate the top lines of income statements.

But taking such a narrow view might be a mistake, causing them to ignore the ripple effects of the change on debt covenants, bonuses, corporate taxes and many other areas of their organizations, accountants suggest.

To be sure, compliance with the sweeping new revenue-recognition standard, on tap for issuance by the Financial Accounting Standards Board and the International Accounting Standards Board in the first half of this quarter, would be a handful in itself. Those working in the software, real estate, auto and similar industries that regularly issue complex, multi-element invoices, for instance, would see longstanding, highly proscriptive rules replaced by a single, principles-based international standard. Although the rules wouldn’t become effective for public companies until 2017 and for private companies a year later, there would be much to do in the interim.

By erasing so many narrowly defined, often industry-based rules, the transformation would add a great deal of subjective judgment and estimation to the process of recognizing revenue. At the same time, the proposed standard, Revenue from Contracts with Customers, would require many companies to front-load those estimates rather than simply wait until revenues are collected to book them.

In turn, the prevalence of the estimates themselves could cause sudden spikes or drastic dives in reported revenue and earnings, according to Dusty Stallings, a partner with PwC. The introduction of judgment into the area of revenue derived from licenses – an area in which many industries lack guidance — is a case in point.

Currently, some companies recognize such revenue as it comes in, while others front-load estimates. In the latter case, a company would likely have a revenue spike because it records much of a sale at a single point in time, followed by little revenue over the remaining duration of the license.

“For many industries, that was an accounting policy choice in the past, but that’s not going to be a policy choice going forward,” says Stallings. “You’re going to figure out which is the appropriate model and be tied to it.”

Under the proposed standard, many companies with complex revenue arrangements would be required to use the front-loaded model. For pharmaceutical and biotech firms and other companies that offer big, long licenses — of, say, 20 years — the revenue volatility could be especially acute, she says.

While not all companies would be prone to such “lumpy” revenue reports, a rule changeover itself could subject many to fits of volatility, Stallings adds. During an interview this week, she listed a number of areas that could be affected by big changes in revenue accounting.             

Sales. CFOs need to make sure that sales staffs grasp the implications of the new model on the deals they’re striking with customers. A written contract may, for instance, merely describe a particular price for a particular set of goods. Then, however, the salesperson might speak to the customer and offer a discount on an additional set of goods as an incentive to buy more. Under the proposed standard, such oral considerations often must be valued and recognized — and that could affect the way discounts and rebates are structured.

Bank covenants. Without any actual change in a borrower’s business, a change in revenue recognized would trigger changes in key metrics on which loans are often based, including net income; earnings before taxes; or earnings before interest, taxes, depreciation and amortization (EBITDA). Lenders should also be alerted to the fact that the borrower’s reported sales over time may not be as smooth as they once were.

Human Resources. Any change in the timing of revenue recognition could affect bonuses tied to corporate sales or income. Finance executives should consider structuring compensation plans to avoid changes spurred merely by new revenue-recognition strictures. “The last thing that you would want is the unpleasant surprise to your employees that they are not getting bonuses, or the unpleasant surprise to the board of directors that the bonuses just went way up without your having thought about it in advance,” Stallings says.

Tax. The timing of a company’s tax payments could change if its recognized revenue changes. More broadly, increasing topline volatility could upset the best-laid corporate tax plans. “If your tax planning strategy was presuming a steady stream of revenue that now becomes more lumpy, you would want to know if that strategy would still work with a different timing of revenue,” Stallings advises.

3 responses to “Revenue Accounting Could Hit Loans, Bonuses”

  1. So, is this set to begin at the same time as the change in Leases. Well, here comes another stock crash, and probably another recession.

    Nearly every stock crash and ensuing recession has been caused by these standards boards making mostly arbitrary changes to accounting methods.

    Even the Great recession, while the biggest blame may be placed on the lenders and borrowers who over borrowed, the reason it became such an issue was because of the Mark to Market changes.

    The crash in early 2002 and the small recession was caused by the change in goodwill.

    You can explain all you want in the financials about the change, but most investors couldn’t read a financial to save their lives, all they see is a drop in revenue, or a drop in net income and sell their stock.

    The accounting standards boards have probably as much power over the economy as the federal reserve does.

    The standards boards suffer from the same thing other groups, including congress suffer from, the feeling that they need to earn their pay. Imagine If one year the board devised the PERFECT set of accounting standards, a set of standards that literally always resulted in correct, easy to understand reporting. The next year the standards board feeling they need to do something to earn they pay that year would change it.

    • Enron was created because FASB created an absolute disaster of a derivative accounting scheme which at one point resulted in Enron being 7th largest company in the world (?!) by revenues. Less than two years later, we found out it was just a result of accounting changes (and SEC being complicit). That Frankenstein creation had a potential to destroy a lot of good energy companies, luckily bankruptcy process was not subverted by then yet and so the process worked orderly and energy commodities market recovered.

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