Revenue Accounting Could Hit Loans, Bonuses; The prevalence of estimates in the new revenue recognition standard could cause sudden spikes or drastic dives in reported revenue and earnings

March 13, 2014

CFO.com | US

Revenue Accounting Could Hit Loans, Bonuses

The prevalence of estimates in the new revenue recognition standard could cause sudden spikes or drastic dives in reported revenue and earnings.

David M. Katz

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.