Revenue recognition

Earnings reports are about to get a lot more useful, if you read the footnotes

May 29, 2014
May 29, 2014

Of all the accounting concepts, revenue seems like the simplest. When a customer pays you for a product, you record it as revenue.

But nothing in accounting is ever that straightforward, and CFOs’ ability to game what they report as revenue has a long and sordid history. Fiddling with how and when to record sales as revenue has played a part in just about every big accounting scandal in the recent past, including at Enron and WorldCom.

When companies sell complex products or services that are delivered over long periods of time, and include promises of upgrades or maintenance as part of a package, the rules on when to recognize that revenue are fiendishly complex. And where there is complexity, there is a temptation to exploit it in order to flatter financial results, sometimes fraudulently.

That’s why it’s a big deal that US and international accounting bodies announced new joint standards on revenue recognition yesterday. The convergence project has been in the works for more than 10 years and will replace around 200 ad hoc rules and industry-specific standards. (Told you that revenue accounting is a minefield.)

The new standards, which come into force in 2017, won’t affect the amount of revenue a company reports, but could alter its timing. For various reasons, software companies are likely to record revenue more quickly than in the past, while automakers will need to defer it for longer. In general, a standardized international approach to measuring revenue has been broadly welcomed by the business world, especially by investors who want to make apples-to-apples comparisons of company accounts in different countries.

You can read much more about the standards from the usual suspects: Deloitte, EY, KPMG, and PricewaterhouseCoopers. The truly intrepid can go direct to the source (warning: 150-page pdf, may induce drowsiness.)

Back to the future

In this thicket of accounting jargon, one thing caught Quartz’s eye. Among the new disclosure requirements introduced by the new regime, companies must reveal details on the pricing and timing of their “remaining performance obligations,” more commonly known as a backlog. Today this is mostly ad hoc and voluntary; the new standards will move this valuable forward-looking information into the audited, attested body of an earnings report (in a footnote, naturally.)

This is a subtle but “enormously important” change in the tone of a company’s accounts, Brian O’Donovan of KPMG tells Quartz:

Financial statements are largely about the past, but the reason people read them is to try to make predictions about the future. This shifts that balance. It feels qualitatively different.

Analysts often pepper executives with mundane questions about the sequencing of contracted sales on conference calls—now they can just look to the report for answers, leaving time to discuss more substantive matters (one would hope.) But this requires them to delve into a report’s footnotes, where the juiciest details about company performance increasingly reside. And so the world’s most important accounting bodies have provided yet more evidence that it pays to read the fine print.

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