Accounting

When It Comes to Revenue Recognition, Financial Executives Need to Translate

A major focus of the Pacesetters in Financial Reporting 2017 conference was the relationship between those with the technical accounting responsibilities and those charged with educating and communicating with investors.

Educating investors about the importance of the new revenue recognition standard set to become effective in 2018 requires senior-level financial executives to rethink their communications skills and overcome their penchant for technical accounting jargon.

“As a bunch of accountants, we understood what the impact was,” said Stacy Harrington,  Senior Director, Corporate Revenue Assurance at Microsoft at the recent Pacesetters in Financial Reporting Conference in New York last week. “But [the questions is] how to communicate that to senior leadership and investor relations — and then have them then interpret it to investors.

A focus of one session at the Pacesetters conference was the relationship between those with the technical accounting responsibilities and those charged with internal and external communications As early adopters of the standard, Microsoft’s Harrington and Kristen Chester, Senior Manager, Investor Relations shared that their teams began communicating long before the effective date.

Chester shared, “We started getting questions about this from an investor perspective about a year ago and it was clear early on that there was some anxiety about how we were going to go about implementing this new standard and the type of information that we were going to provide to analysts and the investor community.”

One thing that Microsoft considered early on was what to share at the outset to investors and analysts to help them understand the process and so they would be able to plan for the significant changes.

“As you saw in the Microsoft presentation, investors don’t actually focus on these things until after the standard is issued,” Sandra Peters, Head of the Financial Reporting Policy Group at the CFA Institute, said. “The ironic thing is that we’re always telling people at the CFA Institute that we need to work on this, but they tell us the members aren’t talking about it. But we know they will in a decade. Now we’re finally getting the opportunity to illustrate that the things we’ve been working on are actually member-relevant.”

Peters provided the audience with an investor’s perspective and shared the top ten investor considerations.

  1. Should investors expect a change in revenue recognition for all investee companies?

Not all companies will have a change in how they recognize revenue.  “The key thing we’re telling our members is to develop your own expectation with respect to what’s supposed to happen. For some companies, nothing will change but for more complex business models, there will be change,” said Peters.

“We think it’s a great opportunity for investors to better understand the contracts with customers, and the estimates and the quality of earnings that management is talking about.”

  1. How is the investee company’s industry being impacted?

The impacts of the new standard will differ by industry. Peters advised companies to review non-authoritative publications that the firms have done related to certain industries, as they give helpful insight on what might happen for the particular industry that the investor or analyst follows.

Peters pointed out, “the top-line news to investors is revenues changing, but costs can also change.” The disclosure of contract costs is a major area of change for many industries.

  1. What disclosure is the investee company making regarding the impact of adoption?

A May 2017 global survey by UBS asked respondents “What is the expected impact of the new topic 606 (IFRS15) rules?”  61 percent of the companies had made no comment on the impact of adoption, 33 percent said there was no impact, and 6 percent said there was a material impact. This raises the question: are companies who provide no comment (the majority of companies) behind in their analysis or ultimately expect no impact of the new standard?

  1. What method of adoption and transition is the investee company choosing?

The same survey revealed that when asked how the company is transitioning to the new rules, 70 percent did not disclosure, 9 percent had chosen full retrospective and the remainder, 21 percent, chose modified.

The retrospective application is the preferred adoption method for investors because of comparative periods, Peters said. She shared that the CFA Institute has heavily advocated for the retrospective method because it’s most indicative and helpful in explaining trends.

  1. Is only the revenue caption on the income statement changing?

Investors should look at all the income statement line items.

Peters said, “Remember the corresponding balance sheet account changes, because all of these have an opposite effect on the balance sheet when we make these adjustments. Some analysts focus so heavily on the income statement that they forget about the balance sheet.”

  1. Is cash flow changing?

“This is the bottom line most important question,” Peters told the audience. “We focus on a fundamental valuation approach and we focus on cash flows. The impact of the standard, at least retrospectively, shouldn’t have any impact on cash flows.”

  1. Will ratios be impacted?

The most important ratio that the CFA promotes the use of is the return on equity (ROE).

“If revenue changes and earnings changes, basically almost every element of [the formula to determine ROE] will change. It’s important to think through the bottom line of what happens on the income statements, what happens to the ratios, and what happens to cash flow. For preparers, that’s ultimately what the investor’s trying to discern and figure out, ” Peters said.

  1. Will valuation multiples change?

It depends, Peters argues. If there’s no cash flow change and there’s no discounted cash flow change, unless perception of risk changes discount rate. “I think that, to the degree to which a learning about the quality of earnings or a different estimates give investors a different perspective, their views on growth and rate of return may change.”

  1. Will the company’s non-GAAP measures change?

“What’s most important to consider is to exercise caution if you’re making adjustments to cash or you’re using EBITDA as an estimate of your cash because it may change but the real cash may not actually change,” Peters explained. “There are innumerable non-GAAP measures to consider such as adjustments to historical accounting and the degree to which non-GAAP measures are changing or not changing, which can tell you what management thinks of the earnings process and what they think is more useful.”

  1. Are there disclosures which will describe revenue and the change in revenue?

The CFA Institute has been huge supporters of disaggregation of revenue, but Peter says it has concerns with respect to some of the other disclosures, including disclosures to financial statements and too many estimates and judgments.