Better revenue recognition at long last?
Monday, 09 August 2010

By Ronald Fink

Concerns expressed by some observers about proposed new accounting rules for recognizing revenues are overdone, according to an analysis released today. The proposed rules, which generally treat revenue in contractual terms, were released last June last month but have received far less attention than new standards for valuing financial assets and liabilities, in part because of the banking industry's heated opposition to fair value.

While critics have complained that the new revenue recognition rules could let companies play even more games than they do now in the recording of revenues, the analysis suggests that complaint is misplaced.

In particular, the rules would require companies to estimate the price of a transaction in ways that go beyond any cash received. And some have complained that such estimates would allow companies to record more revenue in a given period than they should.

The new rule is the product of a joint project by the Financial Accounting Standards Board and the International Accounting Standards Board and is scheduled for completion in mid-2011, though its starting date has yet to be determined and its implementation would gradually take effect.

In the analysis dated July 16 but released today, Jack T. Ciesielski, an accounting expert who publishes the Analyst's Accounting Observer, noted that companies would have to take into account specific considerations, including contingent amounts, credit risk and present value, in arriving at their estimates.

"Some observers have made a big deal out of the fact that firms will be allowed to estimate transaction prices in recognizing revenue, which sounds like an invitation to disaster," Ciesielski wrote in a note accompanying his report, "but once you look at the criteria, you'll see it's less dramatic than it sounds."

He also noted that the rule wouldn't prevent companies from using the percentage-of-completion approach to recognizing revenue, as some observers originally feared.

Ciesielski noted that such an approach could continue to be used so long as the customer controls the work in process. However, he acknowledged that meeting that test could result in revenue recognized less smoothly from period to period.

The analyst also noted that the rules will limit companies' ability to engage in the sort of "channel-stuffing" practices that brought down Sunbeam in the late 1990s. In order to book revenue from a so-called "bill and hold" transaction, for instance, the customer would have to request it. Also, the product would have to be ready for delivery at the time specified, or to be specified, by the customer. And the firm could not use the product or sell it to another customer.

Ciesielski also applauded what he called the proposal's "greatly expanded" disclosure requirements, which include information about changes in contract assets and liabilities and the lapsing of remaining revenue to be recognized in future periods. The first would help investors determine how much of a company's revenue was the result of acquisitions and how much was derived from organic growth, he noted. The second would give investors a better idea than they often now get of a company's backlog, the analyst said.

Such requirements would result in "both quantitative and qualitative information about the most important number in the income statement - something that's been in short supply for years," Ciesielski wrote.

More generally, he observed that the rules' contract-based approach to revenue recognition is in line with recent changes to the approach to software and other products that include service arrangements and other so-called "deliverables."

And in his accompanying note, Ciesielski called the proposal "an improvement" over the approach currently in place, which he said seemed to be standards issued annually "to patch and repair the other revenue recognition accounting standards in place," and which seemed to be aimed at stemming one type of abuse after another.

He also said the rule might be more significant than FASB's much ballyhooed fair-value pronouncements. "This proposal may affect the revenue reporting of firms even more widely," Ciesielski wrote.

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