The revenue recognition project has become a mess. Even the AICPA was forced to say as much to the FASB, while at the same time knowing that it would likely kill any prospects of IFRS adoption. But, the AICPA's definition of a mess is different than mine: theirs is that too many dues-paying oxen will be gored unless more exceptions, exemptions, accommodations and all that other stuff will be added; mine is that the original goals of the revenue recognition project have become obliterated.
This is what I believe the Boards had envisaged way back in 2002:
- Revenue recognition would be consistent with the way that expenses were supposed to be recognized: that is, defined in terms of changes to assets and liabilities. In particular, deferred costs, would no longer be recognized as assets. And since the criteria for recognition and measurement of assets and liabilities should be broad-based, a revenue recognition standard would be able to comprehend all transactions with and entity's customers, regardless of industry.
- Performance obligations would be measured at fair value.
- Revenue would be recognized as "performance obligations" are satisfied.
- Since a performance obligation is a liability, the project would propose a new conceptual definition of a liability for the sake of added consistency.
- Since the new standard would also be principles-based, it would apply to all arrangements with customers, be they consulting contracts, long-term construction contracts, software sales, leases, and even insurance – an area where no IFRS standards even existed.
The way I see it, this project has become a failure because the boards bit off too many special interests than they could chew at one time:
First came the scope exceptions. One of the great ironies for me is that if there is any industry for which the concept of a performance obligation is central to revenue accounting, it would be the insurance industry. Indeed, the boards originally intended for this project to pave the way for IFRS to cover the insurance industry. Yet, the insurance industry clearly wanted no part of this project, and the boards clearly knew that they would get steamrolled in a political battle with them. Lessor accounting is also a controversial topic the boards are struggling to complete as a separate project, so that was scoped out as well—again, for no principled or even practical reason other than political pressure.
Then came attacks on fair value measurements. One of the recurring themes of this blog is that exit prices (as opposed to entry prices) create accounting problems literally from Day One. Expensing transaction costs to acquire financial instruments is just one example the boards have had to cope with, but the even more vexing problem has turned out to be Day One gains from being able to settle performance obligations for less than what was received from the customer. For example, a company that sells an extended warranty on an automobile for $1,000 might be able to immediately subrogate their liability to some other company for a payment of $800. Thus, the fair value of the warranty is only $800, and the Day One gain is $200. The obvious (to me, at least) solution is to measure a performance obligation by the customer's replacement cost of its asset to receive warranty services over the extended period (still $1,000). But the boards traveled too quickly and too far down the fair value road to admit their errors without significant loss of face.
Consequently, in a desperate attempt to save their revenue recognition project (an integral element of convergence) from destruction, the boards pivoted away from fair value measurement and eventually settled on the time-worn notion of allocating the total arrangement consideration amongst the performance obligations in proportion to their respective fair values.
As with any allocation process in accounting, such an approach to measuring performance obligations has raised a whole host of ineffable questions. When is more than one contract an arrangement? When is one contract more than one arrangement? How to measure arrangement consideration? Most fundamentally, what attribute of the performance obligation is being measured?
I'll give you two examples of how silly the consideration allocation approach is:
Example 1: My son lost his cell phone yesterday (true story, but the numbers are made up). So we had to buy him a new phone, and at the same time, we bought him a new service plan. The bundled plan cost us $400; but if the phone and service plan had been purchased separately, they would have cost $300 each. Therefore, the proposed accounting would allocate $200 of the arrangement consideration to the "phone sale" and the same amount to the "service plan" performance obligation. If the phone had a carrying amount in inventory of $250, then the seller would have to recognize a $50 Day One loss on the phone sale. Therefore, all of the profits from the arrangement plus $50 would be recognized over the term of the service plan.
The moral of the story is that absurd accounting is likely to result in absurd managerial decision making. If for no other reason, this standard will destroy shareholder value.
Example 2: On the last day of a hospital's fiscal year, I checked myself into an emergency room due to severe abdominal pain (another true story – but the date is made up). When measuring the arrangement consideration becomes an integral part of revenue measurement (it is currently a recognition criteria), how on earth will the hospital be able to determine how much revenue it should recognize? So far, all it knows is that I have primary insurance coverage (lucky for them). It doesn't know whether a deductible will apply, whether I have a secondary policy, whether I am creditworthy, or whether I will attempt to negotiate a lower payment (I did). There are probably at least another five sources of uncertainty that I haven't mentioned, yet somehow the issuer is supposed to take them explicitly into account to come up with a number representing the arrangement consideration. And then, it has to discount that number at some appropriate rate of interest.
To this second example, there are two morals. The first is rather obvious: all the new systems that would be required to measure consideration in accordance with GAAP are not likely to provide better information to investors – just more jobs for accountants and auditors. The second moral is even more compelling, because it explains why healthcare providers don't seem to be protesting too much to the proposals: these complex procedures are a juicy opportunity for earnings management. How an auditor could be expected to reign in "unreasonable" probability distributions or even discount rates is a mystery to me.
Then came the construction companies who were afraid that the elimination of percentage of completion accounting would inhibit their abilities to manage their revenues and expenses. So just to get their buy-in, the boards added to the project all manner of opportunities to defer all sorts of costs, completely ignoring the balance sheet approach, which was supposed to be one of the two cornerstones of revenue recognition — that and fair value.
And, I haven't even discussed the reasons why nobody has figured out how to revise the definition of a liability. That could take all of the wiggle room out of the definition of a performance obligation, and no issuer wants that.
The bottom line is that even after nine long years of prodding, cajoling and improvising to the point that most of the original goals for the revenue recognition standards have been long cast aside, issuers are still hopping mad. Hardly anyone actually cares whether the new rules will result in consistent application of straightforward principles, which was the reason for the project in the first place.
All issuers seem to care about is whether their expected revenue and profit streams will be as smooth, or smoother, than they currently are. All the FASB and IASB seem to care about at this point is placating the issuers – just to get something that looks like a converged revenue recognition standard out the door.
Holy unintended consequences!