Are we ready for principles-based revenue recognition?
As a firm, we’ve spent considerable time and energy helping clients understand and create a roadmap for the new revenue recognition standard that’s scheduled to go into effect in 2018 and 2019. The new guidance provides a principles-based, five-step process for recognizing revenue that’s in sharp contrast to the current rules-based, industry-focused standards that have been in use for decades. But how will the market respond to financial statements based on the new standard? And how will regulators oversee the reporting process once the standard goes into effect?
Under the current standards, many industries have specific revenue recognition rules that have developed over time to address unique aspects of their business models. For example, when comparing financial statements for software companies, we can expect that the revenue each company recognizes from licenses is determined using the same rules. Under the new principles-based standard, the industry-based rules have been eliminated in favor of a single five-step process that will be applied to customer contracts by all entities.
For a software company, the new principles-based revenue recognition model requires each license arrangement to be analyzed to properly identify the promises made to the customer (referred to as performance obligations), estimate the value of each, and recognize a portion of the total revenue as each obligation is fulfilled. There aren’t many companies that have only one form contract for all transactions, much less industries where competitors all use the same contract terms. Under the new guidance, two competing companies could recognize contract revenue on completely different timelines and still comply with GAAP. To use the roadmap analogy, two competitors could correctly follow the roadmap and each wind up in different locations.
The general thought is that the marketplace and regulators are willing to accept this new diversity because the tradeoff is more uniformity across industries.
Given this potential “diversity” in financial statements, it seems like a good time to ask how the market and regulators might respond once the standard goes live. If two similar organizations examine their contracts and come to two different but equally sound and supportable conclusions about when revenue should be recognized, have we lost one of the primary benefits of GAAP, which is comparability across financial statements of different entities?
The general thought is that the marketplace and regulators are willing to accept this new diversity because the tradeoff is more uniformity across industries. Plus, once the new standards have been in use for some time and the accounting industry begins sharing ideas, best practices are bound to develop that will narrow the gaps. If there’s too much diversity, however, history tells us that the SEC and other regulators will likely step in and provide any standardization that’s deemed necessary for publicly listed companies.
There are many questions to answer before the standard goes live. In fact, it’s possible that some significant questions haven’t even been asked yet. As we move forward, the knowledge, experience, and viewpoints of key stakeholders, including regulators, accounting standard-setters, and others will have a profound impact on what the final implementation looks like. But make no mistake — things will look much different than they do today.
And that’s my last word.