Investors Worry Revenue Rules Will Allow Earnings Manipulation

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By Steve Burkholder

Some investors worry that revenue accounting rules that public companies must begin using in January will yield inconsistent reporting and allow earnings manipulation, according to Bloomberg BNA interviews with investors and their advocates.

The new U.S. and international accounting rules on revenue—deemed the most important single line in the financial statements—call for significant judgments by companies.

“The fear is that companies will take advantage of that,” David Zion, of Zion Research, New York, said May 26 of the leeway in the new rules. “The fear is the aggressive representation.”

At Morgan Stanley & Co. LLC, analyst-accountant Todd Castagno said May 31 that a shift to the Financial Accounting Standards Board’s 2014 rules on revenue, ASC 606, likely will yield “potentially more volatility and unpredictability” in revenue bookings “because of the required judgment that the standard prescribes.”

Regulators Watching

The revenue standard, jointly issued with the International Accounting Standards Board, promises big changes for many companies in how and when they report revenue. Incorrect revenue reporting—long a top target of enforcement by U.S. securities regulators—could lead to unwelcome restatements of results by companies.

The views of investors and security analyst carry weight. Institutional investors, such as big pension funds and hedge and mutual funds, scrutinize reporting under generally accepted accounting principles on revenue. Top investors can help guide the flow of many hundreds of millions of dollars into companies.

The accounting rules “could cause revenue to be recognized earlier or later, lumpier or smoother,” according to Zion, who formerly worked at Credit Suisse First Boston and Bear Stearns. “It will impact all companies (to varying degrees).”

“The key question is will it change behaviors,” Zion wrote in a recent report on the revenue standard. “For example, will management try to adjust their contracts with customers to get a better revenue recognition pattern or launch new products because the revenue recognition will make more sense?”

Zion also warned of inappropriate financial reporting behavior in his firm’s preview of the shift to the sweeping revenue standards.

The rules will bring more management judgment to top-line revenue numbers, including on estimates of revenue and on when to book revenue on long-term customer contracts that are subject to change and variable payments.

‘Monkey Business’

“In theory that should mean revenue will better reflect the underlying economics,” according to the Zion Research Group’s report. “In reality, it may result in some monkey business.”

FASB issued the revenue rules—some 12 years in the making—to have one set of accounting principles replace scores of items of disparate, industry-specific accounting guidance. Board Chairman Russell Golden said on the 2014 release of the standard that “it will eliminate a major source of inconsistency in GAAP.”

FASB and the Securities and Exchange Commission staff also place much weight on enhanced footnote disclosures on revenue that are aimed at having companies telling a fuller story, including on “backlogs” of goods and services that are yet to be delivered and performed.

“We want investors to get as much benefit out of those as we can,” Marc Siegel, a FASB member, said May 30 of the disclosures.

The board has started an investor education effort, with a series of webinars on the revenue standard.

Morgan Stanley’s Castagno told Bloomberg BNA May 31 that the upcoming revenue standards broadly achieve FASB’s and IASB’s goal of making possible comparable reporting on revenue among companies, both within commercial sectors and across borders.

However, kinks likely will have to be worked out, particularly in the first years of the rules’ use, Castagno and others predicted.

Because the standards are built on principles rather than prescriptive rules, “there will be idiosyncratic differences” and different accounting conclusions, “even within industries or within peers,” Castagno told BNA. He predicted that those will iron out over time.

Waiting to See

Sandra Peters, chief of regulatory engagement at CFA Institute, the global chartered financial analysts group, said May 30 that she has adopted a wait-and-see attitude on how reliable and transparent financial reporting will be under the new FASB and IASB regimes.

She and Castagno voiced uncertainty about how the enhanced footnote disclosures on revenue might mitigate the judgments to be made by companies and different accounting conclusions they might draw.

“I’m a little nervous that the disclosure hopes” of FASB might be overshot a little, Castagno said. “That’s something we’re going to have to wait and see” on, he said. Peters said she’s taking “the show-me approach” regarding footnote reporting improvements.

More Reliance on Cash Flows

Both Peters and Castagno said that in view of the new judgments on revenue reporting that will have to shake out, investors will rely more on measures of cash and cash flows.

Actual cash from revenue “is still what matters,” Peters told Bloomberg BNA.

Former SEC Chief Accountant Lynn Turner is less sanguine about the move to the 2014 revenue rules than other investors and investor advocates that Bloomberg BNA interviewed.

Turner has been an outspoken critic of subpar financial reporting, deficient auditing, and what he views as lax regulation.

“Poor judgments by accountants and companies, as well as their auditors, have often been at the heart of corporate financial reporting scandals,” Turner, who served under SEC Chairman Arthur Levitt Jr., from 1998 to 2001, said May 31. “This new revenue standard increases the use of judgments and in doing so, increases the possibility that financial statements will be manipulated to the detriment of investors.”

To contact the reporter on this story: Steve Burkholder in Norwalk, Conn. at sburkholder@bna.com

To contact the editor responsible for this story: S. Ali Sartipzadeh at asartipzadeh@bna.com

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