Navigating Through the Ripple Effects of Forthcoming Top Line Changes

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Vincent Papa

By Vincent Papa, CFA CPA

Vincent Papa, Interim Head Financial Reporting Policy, based in Brussels, has approximately ten years’ experience in developing financial reporting policy for capital markets at CFA Institute, EMEA. Vincent is a spokesperson and author of content articulating investor perspectives, on a range of reporting issues including US GAAP and IFRS, Non GAAP financial measures and broader corporate reporting reform.

Papa serves on the European Financial Reporting Advisory Group (EFRAG) user panel and European Securities Markets Authority (ESMA) Corporate Reporting Standing Committee. He previously served on the Financial Stability Board Enhanced Disclosure Task Force, IFRS Advisory Council and Capital Markets Advisory Committee.

Prior to joining CFA Institute in 2007, Vincent had thirteen years’ experience in a variety of roles including fixed income securities analysis, management consulting, and auditing.

He holds a Masters in Finance from London Business School and a doctorate in management from Cranfield School of Management in the UK where he completed his doctoral thesis on derivatives accounting and earnings management.

Companies are on the cusp of a new era of top line reporting as the International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP) revised revenue recognition requirements (IFRS 15 and Accounting Standards Codification (ASC) Topic 606) become effective from the beginning of 2018.

The revised requirements present a landmark change, affecting companies’ portrayal of performance and potentially impacting their reporting incentives, compensation and debt covenants. The changes are also crucial for investors, as revenue is an important performance measure, a valuation input, and an indicator of management quality and integrity.

The Case for Change

Current IFRS and US GAAP revenue reporting have been characterized by several deficiencies (i.e. avoidable complexity, limited comparability and poor disclosures) that necessitated an update of their underlying requirements. Current US GAAP is comprised of more than 200 pieces of revenue-related literature that are often industry-specific and developed in a reactive fashion.

The plethora of industry-specific guidance has contributed to enormous and unnecessary complexity. For example, it necessitates investors who cover a wide portfolio of companies to have mastery of a continually growing mountain of bespoke revenue reporting approaches across industries. It has also led to inconsistencies due to economically similar transactions across different industries having differing revenue accounting approaches.

The new guidance is more principles based than current US GAAP and aims to create greater consistency in accounting for economically similar transactions.

The update was also an opportunity to fill gaps within current IFRS requirements. Under IFRS (IAS 11- Construction Contracts and IAS 18— Revenue), there has been incomplete guidance related to the accounting for customer contracts with multiple-deliverables, leading to a situation where several IFRS reporting companies (e.g. software companies) often have had to rely on US GAAP for reporting revenue.

For example, European software companies SAP and Sage apply US GAAP for revenue recognition.

Another motivation for change and a strong draw for support from financial reporting stakeholders and especially investors, was the opportunity to have globally comparable revenue reporting across the US and IFRS compliant countries.

Finally, perhaps the most critical shortfall with revenue reporting for investors has been the poor state of disclosures. Companies tend to provide detailed disclosures for pensions, financial instruments etc. but, rather oddly, the provision of such detailed disclosures has not extended to revenue, despite it being arguably the most important line item on the financial statements.

Revenue disclosures (including within the segment reporting sections) tend to be barebone, boilerplate and inconsistent across companies. The update to a large measure has strengthened the related disclosure requirements.

How Are the Requirements Changing?

Change in Building Blocks of Revenue Recognition - Under existing US GAAP guidance, revenue recognition is based on the following requirements: a) persuasive evidence of an arrangement; b) delivery has occurred; c) the fee is fixed and determinable; and d) collectability is probable.

IFRS has principles that are largely similar to US GAAP and revenue is recognized when ‘earned’ and ‘realized or realizable’ with an emphasis on transfer of risk and reward as a criterion of recognizing revenue.

Customer contracts (i.e. explicit or implied promises by a seller to deliver good/s, service/s, license/s in exchange for compensation from the customer or to use the legal term-customer consideration) are the central reference point for the new requirements.

The new model’s building blocks are five interdependent steps: 1) identify the contract; 2) identify separate performance obligations; 3) determine transaction price; 4) allocate transaction price; and 5) satisfy performance obligation. Hence, the requirements are sometimes described as the “five-step model.”

Expected Customer Consideration to be Allocated Across Distinct Deliverables - Step 2 requires companies to identify the distinct promises or deliverables (e.g. goods, services, licenses) that they are making to the customer (i.e. distinct performance obligation). Distinct simply means a deliverable that can be sold separately even though it may be part of a bundled good, service or subscription access offering within a customer contract.

A popular example is a handset within a mobile phone contract that can be gotten from one provider but can be sold and/or used for subscription access to a different mobile company provider. Steps 1-4 then help to determine the amount that is expected to be received from the customer and how that is apportioned to each distinct promise. Essentially, steps 1-4 determine the amount of revenue that is to be recognized for each distinct deliverable.

These changes mean that there will be no more “free” customer handsets issued by mobile companies as these companies will apportion to the handset, part of the consideration or compensation that they expect to receive from customers over the contract period and this will result in revenue recognition at the inception of customer contracts.

The upfront allocation of revenue will effectively lead to an accelerated revenue recognition pattern for telecommunication companies. Similarly, Microsoft, which is one of the few early adopters, has indicated that it will bill hardware makers for Windows 10 at the time of sale rather than through the life of the PC or hardware as the software is a distinct product.

If the new approach had been applied in 2016, Microsoft’s revenue would have been $6 billion (7 percent higher) than was stated. It is worth noting that for software companies, future upgrades to their existing customers’ software will be apportioned a part of the customer consideration. This is a shift from current US GAAP where allocation to unfulfilled promises has been heavily constrained by the need for vendor-specific objective evidence prior to doing so.

Another example of the effects from the requirement to apportion revenue by distinct deliverable is from British engine manufacturer Rolls Royce. For many years, Rolls Royce had tended to bundle its loss-making engine sales and long-term after-market service within linked total care contracts and this allowed the cross subsidization of margins across these differing deliverables.

Under IFRS 15, Rolls Royce engine sales are fully recognized upfront and this will change the reported profitability profile. In its communication of the impact of IFRS 15 on 2015 revenue, Rolls Royce showed a downward revision of £900 million of both revenue and gross profitability, in part due to the determination of revenue of linked, total-care contracts. This was done on the basis of splitting these contracts into individual, distinct original equipment sales and after-market services components.

Revenue Timing Depends on Transfer of Control- Step 5 mainly determines the timing of revenue recognition. In other words, it determines whether the expected amount to be received from customers for a sale is to be recognized by the seller at a single “point in time” on completion of performance, or whether it is to be recognized “over time” and depending on the pattern of “transfer of control” of distinct good/s, service/s, or license/s to the customer.

In effect, Topic 606 and IFRS 15 guidance is premised upon a recognition of revenue on transfer of control rather than on transfer of risk and reward. The shift to transfer of control as determinant of revenue recognition is a nuanced but important difference that could impact on the timing of revenue and is particularly critical for companies with long-term contracts such as for real estate developers and contract manufacturers.

Less Conservative Treatment of Uncertain Revenue- Current guidance is quite conservative and heavily constrains the recognition of uncertain customer consideration. Examples of uncertain consideration could include a) an asset manager whose fee is based on fund performance exceeding a future period market benchmark; b) a retailer who issues gift cards and is uncertain of the unredeemed sales (i.e. gift card breakage); c) a semiconductor manufacturer that distributes its products through third-party distributors and faces risk of product obsolescence and related returns.

Under US GAAP, revenue is recognized only when the fee/consideration is “fixed and determinable,” setting a high threshold for the recognition of revenue. The newly issued requirements are less conservative as they have dispensed with the requirement of consideration being “fixed and determinable” prior to recognition of revenue and instead require the estimation of variable consideration (Step 3)- subject to the constraint of it being probable that there will not be a significant reversal of revenue in the future. Hence, the new guidance will likely result in accelerated revenue recognition across many businesses including by a variety of retailers and manufacturers.

Updated Cost Recognition Requirements - The revised requirements have updated revenue-related cost recognition approaches, as these have tended to be quite opaque. Costs to obtain and costs to fulfill customer contracts (e.g. sales commissions). To the extent that companies’ will capitalize and subsequently amortize or impair more contract costs than they currently do, there will be a greater matching of revenue and costs and smoother margins over the life of the contract. This could change the profitability profile of companies with long-term contracts.

Expanded Disclosures- IFRS 15 and ASC Topic 606 require the following mandated disclosures: a) significant judgments and changes in judgments; b) disaggregation of revenue; c) changes in contract assets (analogous to unbilled receivables under current guidance); d) changes in contract liabilities (analogous to deferred revenue under current guidance); and e) performance obligations (>1 year). US ASC Topic 606 requires public companies to provide these disclosures in both annual and interim reports. IFRS 15 requires these disclosures only for the annual reports.

The disclosure specification within the issued requirements was a balancing act by the accounting standard setters as they tried to balance between user expectations for significantly enhanced, specific and detailed disclosures and preparer concerns on compliance costs associated with detailed disclosures.

What will be helpful for investors is for companies to adhere to the spirit of being more transparent about the nature, drivers and future potential of reported revenue rather than treating the disclosures as a compliance burden. Companies often provide revenue-related information (e.g. order backlog) in other forums outside the financial statements (e.g. company presentations; management, discussion and analysis (MD&A)/narrative reporting sections).

To be fully transparent, enhance access and optimize the reliability of the information provided, companies should focus on ramping up the quality of revenue information provided within the financial statements- as such information is subject to audit, robust internal control framework and oversight by those charged with governance.

Reporting Changes Could Lead to Business Transformation

Customer contract features (e.g. the mix of goods, services and licenses within contracts; contract terms; the form and timing of payment to be received from customer; unexercised customer rights; financing arrangements; terms that dictate whether or when the seller controls a good, service or license) will affect the timing of revenue for different businesses.

Hence, changes could occur in software, aerospace, engineering, construction, contract manufacturers, real estate, telecommunication, healthcare, a variety of manufacturers, retailers, e-commerce firms, asset management firms, and other intellectual property-intensive firms.

That said, anecdotally, many companies tend to assert that they will be minimally affected by the revised requirements. Perhaps this could simply reflect that some companies are yet to complete what in many cases is likely to be an extraneous review of their portfolio of customer contracts.

Yet, it is not inconceivable that the complexity and multiple, significant judgments of the revised accounting changes could result in more far reaching and diverse impacts than is generally anticipated. One consequence of the accounting revision is that some companies may end up modifying their customer contracts to allow desirable revenue recognition and profitability patterns. For example, software subscription services (SaaS) contracts could end up being separated into software & hosting arrangements should the accelerated recognition of fees received from subscribing customers as revenue be a desirable reporting pattern for cloud computing businesses.

Companies often highlight the significant implementation costs that they face from the revised requirements, but these changes also present opportunities for better management of businesses. For example, the focus on apportioning revenue by distinct deliverable could result in greater transparency on and accuracy in reporting of product profitability. In turn, this could potentially incentivize improved product pricing and cost management.

The rollout of the revised revenue changes could also enable increased internal cross-functional co-ordination within companies whilst different teams review and possibly optimize the impacts of customer contracts across the value chain. Illustratively, a FASB hosted Aerospace and defense sector webcast involving experts General Electric (GE) and Raytheon, the GE speaker described Topic 606 as being one of the most cross-functional changes that the highly-decentralized organization has faced with implications and need for participation from different functional departments (finance, supply chain, sales, tax, IT, investor relations).

Implications for Investors

Despite the general understanding of likely sectoral impacts, it is hard for investors to anticipate effects of the revised requirements at a company level (i.e. whether there will be acceleration or deferral of reported revenue), as there is much heterogeneity in business models deployed and profile of customer contracts of companies within and across sectors.

Investors’ difficulty in anticipating company-specific changes is exacerbated by the following factors: a) there have been very few early adopters of the revised standard, b) many companies are yet to spell out if there will be any material changes due to the revised requirements, c) customer contracts and business models are dynamic, and d) as noted, there are generally poor revenue related disclosures across companies.

Apart from the question of revenue timing impacts, CFA Institute commentary on the changes ( Watching the Top Line, Top Line Watch- Long-Term Contracts) has emphasized the need for investors to pay attention to a) the impact of contract cost recognition and consequent effect on gross margins; b) monitor transition reporting and related disclosures; and c) scrutinize and carefully interpret disclosures particularly those that relate to future revenue (the required disclosure is only a subset of backlog disclosures).

Notwithstanding these potentially significant changes in revenue accounting, investors should always remember that the intrinsic value of companies is primarily driven by the real economics of businesses rather than by accounting changes. In other words, pure play accounting changes ought to have a zero- net present value.

Hence, investors should always distinguish between changes in reported revenue patterns that arise exclusively due to: a) the effects of changes in companies’ accounting judgments on existing customer contracts; b) changes in customer contracts including pricing changes and/or an alteration of the customer value proposition; and c) changes in customer demand influenced by seasonality, economic cycle, shifts in customer tastes, and product obsolescence.

Only the latter two drivers of observed changes in revenue really reflect changes in the economic value of companies. One way investors can keep track of real economic value creation of companies due to selling products to customers is to monitor the cash conversion of revenue as well as the correlation between revenue, gross margins and the cash-flow from operations.

Transition Monitoring

Though we are now in the home stretch prior to these requirements becoming mandatory, many companies are still grappling with and are on a journey of discovery of the effects even when they do not own up to it. Yet any portrayal to investors that not much will change could inappropriately lull them into a false sense of comfort.

The wide variety of required management judgments that can affect the amount, timing and uncertainty of revenue necessitates ongoing due diligence by investors in the run up to and after adoption so that they can appropriately interpret reported revenues and effectively monitor companies’ performance and value creation. The same rigor in monitoring impacts will be required of those charged with governance and oversight of the financial process, such as audit committees.

Transition reporting requirements are meant to help investors discern the effects of revised standard. Preparers can choose between providing full retrospective transition (i.e., 2018, 2017 and 2016), modified retrospective transition with practical expedients, and cumulative catch-up transition (2018 onwards, a cumulative catch-up in opening equity and disclosure of what current year revenue would have been under the old guidance).

The ideal approach for investors would be the full retrospective method but indications are that most companies are going to apply the modified retrospective. The modified approach with practical expedients could result in different companies applying different permutations of practical expedients and significantly reducing the comparability of transitional information across companies.


As highlighted, the revised revenue reporting requirements will result in more comparable global reporting as there will be relatively converged requirements between IFRS and US GAAP; it will reduce reporting complexity emanating from industry specific guidance in the US, and it could yield more informative disclosures for investors.

There could also be cases where there is an opportunity for better management of businesses due to enhanced information on individual product profitability.Despite the mentioned upsides, there are also risks particularly those that tend to be associated with judgment-intensive accounting principles. Judgment intensive accounting can enable any underlying companies’ incentives to manage performance in a misleading fashion or to result in unintentional errors/misapplication of requirements in revenue reporting.

Hence, it will be instructive to observe whether the changes result in changes in the level of restatements, securities regulators (SEC) queries/comments. Especially as revenue has historically tended to be subject to significant misreporting risk.

Increased judgment within IFRS 15 and Topic 606 also heightens the important role of auditors and audit committees and the need for them to exercise professional skepticism when auditing or overseeing companies’ management judgments that influence revenue recognition. In this vein, the review of existing audit standards for accounting estimates by the International Audit and Assurance Standards Board (IAASB) is timely.

In sum, the revised changes effects are likely to have far reaching implications for key actors across the financial reporting value chain including companies’ management, investors, audit committees and auditors. They will also have a bearing on the quality of reporting and interpretation of companies’ performance.

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