Peeling away financial reporting issues one layer at a time

Making Revenue Recognition Simple and Informative

One thing that everyone should be able to agree on is that the accounting rules for measuring and reporting revenue ("revenue recognition") are a huge mess. There are too many of them, and far too many inconsistencies amongst them.

One of my favorite examples for illustrating how dysfunctional the rules can be is this illustrative example taken from a 1999 SEC Staff Accounting Bulletin (No. 101):

"A registrant sells a lifetime membership in a health club. After paying a nonrefundable "initiation fee," the customer is permitted to use the health club indefinitely, so long as the customer also pays an additional usage fee each month. The monthly usage fees collected from all customers are adequate to cover the operating costs of the health club. … Question: when should the revenue relating to nonrefundable, up-front fees in [this type of an arrangement] be recognized?"

If all you knew about accounting was that "assets" are what you have and "liabilities" are what you owe, then you should respond that the revenue should be recognized "when cash is received"; the health club has received an asset (from a non-owner), and it has no obligation to return cash at a later date, or even to provide services, under any circumstances.

The SEC, however, enunciated a different point of view in SAB 101, which can now be found in Topic 13 of the SAB Codification:

"Unless the up-front fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process, the deferral of revenue is appropriate. … [T]he staff does not view the activities completed by the [registrant (i.e., selling the membership) as a discrete earnings event.]"

The implication of this illustration is that revenue recognition under GAAP involves more than just the receipt of assets that you don't have to pay back; an implicit performance obligation to provide the customer with future services is deemed to exist, even though the customer has no legally enforceable right to receive the services.

In other words, current revenue recognition practices are dependent on factors that don't play into whether or not the definition of an asset or liability has been met for recognition, its subsequent measurement, or conditions for its derecognition. This disconnect of revenue recognition from the balance sheet, has led to a jagged path of positions hatched industry-by-industry, over decades of political wrangling with issuers and auditors. The resulting complexities, subtleties and inconsistencies within the revenue recognition rules are, at their very best, second only to the tangled web that is financial instruments accounting.

The Epic Revenue Recognition Project

The FASB/IASB joint project on revenue recognition seems to have been initiated as a good faith attempt by them to recapture the high ground from the SEC post-SAB 101 on a topic that arguably is the most consequential to the most financial statement issuers. After seven years (yes, the project was proposed back in January 2002) of consideration, the Boards' position has evolved essentially to these major positions as expressed in a discussion paper for which the comment deadline expired six months ago:

  • The scope is limited to arrangements whereby an entity exchanges promises with a customer, leading to rights and obligations.  
  • Increases in rights or decreases in obligations to customers are recognized as revenue.
  • Performance obligations are to be initially measured by the transaction price, or an allocation of the arrangement consideration; subsequent measurement is still unsettled, but is likely to be a function of the initial measurement (as opposed to a market-based valuation).

The good news is that a new standard would supplant all extant revenue recognition guidance, and become the sole source of guidance on revenue recognition. The bad news is that it won't change much else. I see three major flaws.

First, revenue recognition should be nothing more than a question of income statement classification. If the FASB were fully committed to a balance sheet approach to financial reporting, it would plainly acknowledge and implement the principle that net income is merely a number derived from the changes in assets and liabilities during a period that resulted from transactions with non-owners. Hence, the only revenue recognition problem is determining which of those changes should be reported on the income statement as "revenues."   As it is invariably the case with both Boards, a piecemeal approach is being taken to avoid the larger contentious debate of accounting for rights and obligations in general.

Second, nothing worthwhile can come from including constructive performance obligations in the conceptual definition of a liability. The health club initiation fee example is the most straightforward example I can think of to illustrate this. The timing of services provided will cease to be a criteria, but the Boards are not willing to throw out the notion of a constructive obligation from their respective conceptual frameworks:

 "Sometimes an entity establishes a practice of providng particular goods or services, such as a warranty service.  Even if neither the contract nor the law explicity requires such a service, the entity by its customary business practice may have implicitly or constructively created an obligation that would be enforceable." (para. 3.6]

An "enforceable" constructive obligation?  I don't know what that means.  I imagine that what they are trying to say, but too embarassed to say directly is this: even though no legal obligation exists, an entity would harm itself by more than it would benefit if it just took a customer's money and ran.  Thus, economic forces make a constructive obligation "enforceable" through some sort of market mechanism.

I might be less cynical about the reasons for wanting to recognize constructive obligations if we actually had effective financial reporting gatekeepers. How many auditors will call a potential constructive obligation the way they see it – as opposed to the way management sees it? Investors don't need that kind of financial reporting any more, and their returns don't need to be burdened with the considerable costs of amortizing upfront fees over some fuzzy measure of the expected relationship period. 

Third, measurement of customer-related assets and obligations by allocating arrangement consideration to them is a step backwards from the FASB's putative goal of measuring financial assets and liabilities at their fair values. I presume that the FASB is legitimately concerned about introducing more subjectivity into measurement of assets and liabilities; and more fundamentally, they are rightly concerned that exit values for liabilities will inevitably generate Day 1 gains for vendors.

I can't say that there is a sure-fire solution to fair value measurement's subjectivity, for that will always be present in any approach to current valuation.  But, there is a straightforward way around the problem of Day 1 gains. Consider, for example, a one-year fire insurance policy with a $1,000 up-front premium. If an exit value approach were taken to measure the performance obligation on Day 1 (i.e., the obligation to stand ready to pay for the insured's loss should a fire occur), it would likely cost the insurance company less than $1,000 to cede the liability to a reinsurer; hence, the Day 1 gain the Boards are worried about.

But, here is, yet one more time, the compelling economic logic of replacement cost measurements. As I have stated in numerous prior posts, a liability is most appropriately measured by the replacement cost of the corresponding insurance asset in the possession of the policyholder. That number would, by definition, still be $1,000 on Day 1. Presto change-o, the problem of Day 1 gains disappears!

Summing Up

Revenue recognition is arguably the most significant project the FASB and IASB can undertake. But momentum, such as it was, appears to have stalled following the issuance a full year ago of that discussion paper purporting to contain the Boards' "preliminary views."  I believe this is because the standards setters keep bumping up against inevitable logical inconsistencies. First and foremost, is that the predilection for exit values is birthing a frightening brood of financial reporting anomalies. Here are five that come to mind without thinking about it for more than 30 seconds:

  • Day 1 expensing of transaction costs when acquiring financial assets or applying the "acquisition method" to a business combination;
  • Assigning an exit value to a leased asset that, by contract, cannot be transferred.
  • Recording gains on the completion of a manufactured good before it is sold (specifically scoped out of the discussion paper).
  • Liabilities that cannot be transferred.
  • Asset markets that are either illiquid, or temporarily taken over by distressed sellers. 

I have been told by someone with access to inside information that FASB chair Bob Herz is a replacement cost guy deep down; but, he can't seem to muster the political momentum to alter course away from exit prices. The way I see it, if we continue to reject replacement cost, we are doomed to chasing our tails: (1) try exit values; (2) become discouraged as the logical inconsistencies destroy representational faithfulness; (3) give up and settle for reporting computer-generated random numbers seeded by an historic cost.

As significant as the revenue project is, a reasoned solution is being lost by a destructive problem solving strategy that the late Nobel laureate Herbert Simon and his co-author Allen Newell called "means-ends analysis"  in their 1972 treatise, Human Problem Solving. The danger is that dogged "forward progress" on a portion of a problem may actually set back the solution of the larger problem to which it is apart. After eight years of hemming and hawing, the FASB surely must realize that its approach is clearly not working. Rather than continue to propose partial fixes to flawed models, it would be better off postponing the project until it establishes more pragmatic definitions and measurements for assets and liabilities.   

If it could only solve the larger problem, the problem of revenue recognition would practically solve itself.

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