Did we need the new revenue recognition framework?

By Aarthi Rayapura October 10, 2014

The new IFRS standard, a release nearly 10 years in the making, introduces a single revenue recognition model applicable to all contracts with customers, except leases, financial instruments and insurance contracts. The standard will supersede currently applicable revenue standards and interpretations, including IAS 18 Revenue, IAS 11 Construction Contracts, IFRIC 13 Customer Loyalty Programmes and IFRIC 15 Agreements for the Construction of Real Estate.

Revenue is one of the key figures that investors, bankers, customers, regulators, etc., look for in financial statements to gauge the past performance of a company, as well as its future potential.

But the revenue recognition rules in the Generally Accepted Accounting Principles (GAAP) in the U.S. are different from those used in much of the rest of the world under International Financial Reporting Standards (IFRS).

So why and how did IFRS and the Financial Accounting Standards Board (FASB) think of getting a new framework in place?

A series of companies — including Sunbeam, Xerox, PurchasePro, and Microstrategy–were targeted by the U.S. Securities and Exchange Commission (SEC) in the late 1990s and early 2000s with allegations that those companies improperly recognized revenue, leading some of the companies to pay settlements and restate revenue. Those actions roiled stock prices and market capitalizations.

In 2002, the FASB and the International Accounting Standards Board (IASB) agreed to work jointly to clarify the principles for recognizing revenue and document common revenue standards to remove inconsistencies and weaknesses, improve comparability of revenue recognition practices and simplify the preparation of financial statements for companies. That process has culminated in the new rules, which are now being subjected to a commentary period prior to adoption. After years of deliberation, the FASB issued new guidance for revenue recognition on two highly controversial issues.

The FASB, under Accounting Standards Update (ASU) 2009-13, now allows companies to establish and even estimate selling prices for multiple-deliverable arrangements.

Another new rule, ASU 2009-14, allows makers of computers, cell phones and even cars to avoid special software revenue recognition accounting rules if the software included in the product was incidental or, conversely, essential to the product. Those companies can now estimate selling prices for software and recognize revenue over a different time period than hardware.

“If you think about the old guidance, it was inconsistent with what our economic benefit was,” said Catherine Voutaz, controller at tech firm Fusion-io. “We had deferred revenue on the books that we couldn’t recognize but for which we had already collected the cash. When people went to look at our financial statements, they would ask why we had a huge amount of deferred revenue on our books.”

“(The old guidance) gave investors a view that was not really reflective of reality.”

The new FASB rules amount to “an easier way for us to communicate with our internal investors and the bank,” Voutaz said.

While the new rules directly impact many high-tech companies, they can also apply to other types of businesses that sell products and services together. For example, stores such as Best Buy or Sears might sell refrigerators or washing machines along with a maintenance contract. Likewise, a consulting firm that sells multi-element arrangements–advice and outsourcing services along with software–might price their products in a way that causes the new revenue recognition rules to apply to that business as well. We will discuss many more such examples in our future blogs.

The FASB has released a 52-page document to help explain the basic and complex differences between the old and new framework.

This document has outlined many different aspects of the framework and offers a very good comparison of the differences between the old and new principles. Areas discussed include persuasive evidence, delivery of product or performance of service, collectability, fixed or determinable, constraint on the amount of revenue that can be recognized, loss recognition (onerous test) and many more. For those of you looking to build your foundation on the new revenue recognition principles, this document is a highly recommended read!

Stay tuned for our next post in which we start discussing each principle in detail and also provide you tips on how to implement the new rules in your company.