FASB, IASB Plod Toward Convergence on Revenue

For an economy that isn’t seeing enough revenue these days, the United States certainly does have a lot of ways companies can try to recognize it.

Currently, U.S. Generally Accepted Accounting Principles and GAAPs’ related guidance have more than 180 rules for revenue recognition (including the ones that conflict with others). Contrast that with International Financial Reporting Standards, where the opposite is true: IFRS has almost no guidance for some transactions.

Both extremes cause diversity in practice. That’s alarming, because when you look at common reasons for restatements, revenue recognition is frequently the primary reason. Companies that have to comply with myriad, complex rules may make honest mistakes. Improper revenue recognition is also a nifty way to commit fraud. Clearly, clarification and simplification is needed.

In December 2008, both the U.S. Financial Accounting Standards Board and the International Accounting Standards Board published discussion papers on anew revenue recognition model. The idea was to simplify current revenue accounting by proposing a single conceptual model to use for all transactions consistently under both IFRS and GAAP. Revenue recognition is one of the projects the boards have included in their Memorandum of Understanding to converge standards by 2011. The recent G-20 meeting in Pittsburgh reinforced the worldwide commitment to one set of global accounting standards, and the commitment to complete the major convergence projects; leaders even moved the 2011 deadline to June 2011 specifically.

The discussion paper was intended to ensure consistency and to fill voids by providing a single concept for revenue recognition. The concept proposed is based on a balance sheet approach. This contrasts with the existing model, which is more of an income statement, or earnings “process” approach. Today companies generally recognize revenue when it is realized (or realizable) and the earnings process is complete. The approach in the discussion paper is based on changes to customer contract assets and liabilities. A contract comprises rights and obligations. Any unperformed rights and obligations should be reported on a net basis as either an asset or a liability. The transfer occurs when the customer receives control of the goods or services.

All contracts with customers, whether written or oral, would be analyzed for contract assets (the right to receive payment for goods or services) and contract liabilities (the obligation to perform under the contract). Revenue would be recognized when the contract asset increases or the contract liability decreases—that is, the company satisfies performance obligations to a customer by transferring goods or services.

While this approach sounds straight forward, it is very theoretical and much harder to apply in practice. This new concept will introduce more estimates into the financial statements. Companies are going to have to identify all of the performance obligations in a contract with a customer, and allocate an appropriate value to each item. Companies will also have to identify when each performance obligation has been satisfied. For items that are not sold on a standalone basis, all this may be exceedingly difficult to estimate.

In many cases, the earnings-process approach and the proposed balance sheet approach will have the same outcome. In certain circumstances, however, the changes will be significant. For example, companies that use the percentage-of-completion method for revenue recognition would no longer be able to do sounder the new concept. A company that has, say, a two-year production contract, currently can recognize the “percentage” completed in year one as revenue. Under the new model, revenue would not be recognized until the company transfers control.

What constitutes a transfer of control, precisely? The proposal isn’t clear on that, and it may not reflect the economics of the underlying transactions or provide useful information to investors. The related costs of executing that two-year contract may be recognized long before the revenue the matching concept is not considered in the proposal. For some companies that have long operating cycles, this can create significant volatility in the financial statements and cause a mismatch between revenues and expenses.

Costs were scoped out of the discussion paper, but many comment letters suggested that we can’t talk about one side of the equation without addressing the other, particularly as it relates to long-term construction and programs.

Where We Can Agree

Many believe that a universal approach to revenue recognition may not make sense. Most also agree, however, that the current plethora of approaches isn’t the right answer either. Perhaps two or three models may be more appropriate? In particularly, a separate model for long-term contract accounting may be necessary for the reasons discussed above. Trying to stuff all revenue recognition into one model may just not be realistic.

FASB and IASB also pose some thoughtful questions in the discussion papers. For example, is an obligation to accept a returned good from a customer and to provide a refund a performance obligation? How would it be valued? Some argued that customers expect that the product will work—so isn’t the value zero? Based on the questions posed and the answers the boards received via the comment letters, we would expect to see more guidance as to how to determine the existence of a performance obligation.

The concept of transfer-of-control in the discussion papers did not include the existing guidance on passing along the risks and rewards of ownership. Perhaps the boards should consider retaining the existing guidance to avoid unintended consequences that don’t reflect the underlying economics.

There were also a lot of comments about assigning value to the “performance obligation” of a standard warranty or post-contract support that are not sold separately, or have easily determined stand-alone value that is separable.

This month, FASB underlined its commitment to a new model for revenue recognition by issuing new rules developed by the Emerging Issues Task Force for revenue recognition for multiple deliverables and for products that include software and non-software deliverables. The companies most likely to feel the bite of these new requirements are ones that recognize revenue on a deferred basis due to lack of sufficient objective evidence of fair value for some or all of the deliverables in an arrangement, companies that currently use the residual method for allocating revenue between the delivered and undelivered elements in an arrangement, and companies that have product offerings with both software and non-software components.

EITF Issue No. 08-1, Revenue Arrangements with Multiple Deliverables, applies to multiple-deliverable revenue arrangements previously included in EITF Issue No. 00-21. It provides principles and application guidance on whether multiple deliverables exits, how the arrangement should be separated, and the amount of consideration allocated. It requires a business to allocate revenue using estimated selling prices of deliverables if there is no vendor-specific objective evidence or third-party evidence of selling price. It eliminates the use of the residual method by requiring the company to allocate revenue using the relative selling price method. This differs from current accounting as companies that didn’t have vendor-specific objective evidence of the value of individual elements included in a bundled sale were required to defer recognition of the related revenue for the entire sale. So, expect to see revenue recognized sooner under the new rule.

EITF Issue No. 09-3, Certain Revenue Arrangements That Include Software Elements, focuses on determining which arrangements are within the scope of software revenue guidance and which are not. It pulls tangible products out of the scope of guidance on determining whether software deliverables in an arrangement that includes a tangible product are within the scope of the software revenue guidance. Previously, devices sold with software were treated as software. The new rule will let companies record the device sale earlier.

They are effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June15, 2010, with earlier application or retrospective adoption permitted.

Clearly, the new rules are aligned with the concepts outlined in the discussion paper. This continues the boards’ focus on the “balance sheet” approach to revenue recognition. So while we wait for an official exposure draft on the new revenue recognition model, the boards have obviously already made up their minds. We will likely see the boards continue to support this approach through ongoing rule making.