No one will ever say that U.S. GAAP revenue recognition standards are consistently principles-based, but few would say the system needs to be completely overhauled. Other than to achieve convergence of U.S. GAAP and IFRS, what will a new revenue recognition standard accomplish to improve financial reporting? And at what cost? Before the boards' issue their third exposure draft, they may want to answer those questions.
The sole reason for a joint revenue recognition project was that IFRS revenue recognition standards had huge holes, yet the EU would never have tolerated the details of U.S. GAAP and the attendant loss of wiggle room for the top line number of the income statement. The other side of the coin is that it would be unthinkable for the U.S. to adopt extant IFRS on revenue recognition, or anything even closely resembling that. In short, it wasn't that U.S. GAAP and IFRS were so fundamentally different as to necessitate starting from scratch, but that was the only way to avoid confronting differences that were not fundamental, but where the devil was in the details.
Thus, it comes as no surprise to me that no one has lit a fire under the boards to get a new standard out. Here's a quick list of off the top of my head of the questions that are still up in the air after ten years of "due process":
- Criteria for recognition of revenue;
- Constructive obligations;
- Measuring the transaction price;
- Allocating the transaction price to performance obligations under multiple element arrangements;
- Estimating and presenting bad debts;
- Warranty liabilities;
- "Onerous" performance obligations;
- Costs eligible for deferral; and last but not least,
- Whether the final standard should provide detailed examples, or just wait and see how practice 'interprets' general guidance.
I don't want to beat a dead horse, but it's astounding that practically nothing has been settled after more than 10 years by the discussion papers, draft standards, perhaps a thousand comment letters, hundreds of roundtables, hundreds of thousands of frequent flier miles, tens of thousands of man hours of staff research and the solemn deliberations of the ineffable amongst inscrutable board members.
Not Even Agreement on the Basics
There is indeed much I could choose to write about from the above list, but for starters, this post will focus on the most basic issue: the criteria for revenue recognition. I'll begin with a description of one of the bulwarks against abusive revenue recognition practices in current U.S. GAAP. We'll then review what appears to be the Boards' current tentative conclusion, and then ask whether it would be an improvement over U.S. GAAP.
In 1999, the SEC staff published Staff Accounting Bulletin No. 101 (subsequently updated in SAB 104 and codified as Topic 13 of the SAB Codification), which to my mind is a model of principles-based guidance overarching many disparate rules to be found in U.S. GAAP. It may not have been well-received by issuers, but unlike the FASB and IASB and to the staff's everlasting credit, it didn't seem to care near as much about that.
SAB 101 requires (more accurately, it interprets U.S. GAAP to require) that collectibility from the customer must be "reasonably assured" in order for revenue to be recognized. When goods have been delivered prior to the receipt of cash from a customer, this is taken to mean that there must be a high probability that the customer will pay the company all that it is legally entitled to receive. Hence, for example, "channel stuffing" is streng verborten – pumping goods into a full to overflowing pipeline to a middleman who has the option to return unsold goods to the manufacturer does not lead to revenue recognition merely upon delivery of goods to the middleman.
The "collectibility is reasonably assured" criterion also means that no sales are recognized from sketchy customers until their check clears the bank. To see why this is bedrock U.S. GAAP, take this simple example (which I first used here). Two companies, A and B, differ only in the credit quality of their customers. Company A estimates its allowance for doubtful accounts to be 2% of gross accounts receivable, and B's allowance is 30%. Without the SEC's "collectibility is reasonably assured" criterion, both companies could recognize revenue upon delivery of goods or services.
But, as is inevitably the case, both companies will err in their estimates of uncollectible trade receivables. Perhaps for both companies, uncollectibles were off by a third: that would make 3% for A and 45% for B. The premature recognition of earnings by Company A might or might not be material, but for B, it is hard to imagine that it would not be.
Now, let's begin to consider the boards' proposal. Would you feel better about company B recognizing revenues from its sketchy customers prior to collection if: (a) it was their long-established practice to sell to sketchy customers; and (b) management judged from its past experience that 30% was "predictive" (whatever that means) of the future bad debt rate?
It seems to me that many financial statement users would not be comfortable with B recognizing revenue prior to being able to cash the check, but what I just described seems to be what the boards are proposing – at least according to a Deloitte publication, for I can't even find much of a discussion of the Boards' current positions on their websites. (That by itself ought to tell you something about how well this project is going.)
Anyway, let's rely on Deloitte for the straight skinny:
"The Boards tentatively decided that when an entity satisfies a performance obligation, the entity should recognize revenue at the amount allocated to that performance obligation unless the amount is not 'reasonably assured' to be received. An entity would be reasonably assured to be entitled to the amount of consideration allocated to satisfied performance obligations only if both of the following criteria are met:
a) the entity has experience with similar types of performance obligations (or has other evidence such as access to the experience of other entities); and
b) the entity's experience (or other evidence) is predictive of the amount of consideration to which the entity will be entitled in exchange for satisfying those performance obligations. (page 7, italics supplied)
As a preliminary matter, Deloitte's description contains an ambiguity that I find necessary to deal with: "Reasonably assured to be received" (which sounds a lot like the SEC's current criterion that "collectability is reasonably assured") is not the same as the following sentence, which reads "reasonably assured to be entitled" to receive. Which is it?
The confusion may spring from the back and forth of the protracted deliberations. At first, the boards concluded that revenue should be recognized when the entity is legally entitled to receive (or keep) an amount from its customer*; therefore, they concluded, the revenue from a performance obligation ought to be measured at the expected amount to be collected. It follows further from this line of reasoning that trade receivables would be measured as a function of expected credit losses.
That was a pretty good decision, I thought, but the Boards yielded to pressure from issuers, who evidently decided that they didn't want the responsibility of being held accountable for the estimates – if they could make their earnings targets without them. So, the boards have backtracked towards something similar to current practice, but imbued with typical IASB-style wiggle room (my euphemism for 'management judgment'). If criteria (a) and (b), from above, are deemed by management to have been met, then it's okay to recognize revenue.
Say hello again to channel stuffing, sketchy receivables and even bill and hold sales.
After Ten Years, Has Any Progress Been Made?
There can be no arguing that the revenue project was begun with high aspirations. A new standard would provide greater specificity and consistency to accounting for multiple element arrangements, and it was going to resolve the inconsistencies in accounting for arrangements where performance would be satisfied over time – e.g., construction contracts, customized manufacturing, consulting, etc. All of this was supposed to happen in a principles-based manner, i.e., by treating revenues the same as expenses according to the 'asset/liability view' of recognition and measurement. Just as changes to assets and liabilities determine in which period expenses are recognized, increasing an asset or decreasing a liability would determine revenues for a period. (Under current IASB and FASB standards, for revenues it's always the other way around: meeting the revenue recognition criteria would determine whether an asset would be increased or a liability would be decreased.)
We didn't need to get into the gory details to see just how far short this project has fallen from the boards' stated goals. All we need to do is focus on the general revenue recognition criteria. In my opinion, if we were to jettison U.S. GAAP and adopt the revenue recognition criteria being proposed, it's quite possible that accounting mayhem would ensue. But whether my fears come to pass or not, I cannot think of a single area where U.S. GAAP would be improved by adopting the Boards' proposed replacement for current revenue recognition standards.
Unlike the other two major projects the Boards are grappling with – leasing and financial instruments – to the best of my knowledge, I don't believe a single user has asked either board for new revenue recognition standards. It's long past the time for the FASB to explain why its stakeholders can expect any benefit to come from a completely revamped approach to revenue recognition. No matter what a final standard will look like at this point, all I see coming out of new revenue recognition rules are mountains of wasted resources on compliance by issuers and lots of new "interpretive guidance" from regulators.
If the FASB can't satisfactorily explain how the revenue recognition project will benefit users, it should abandon the project and leave the IASB to take it where the EU wants it to go.
*Assuming the absence of a "constructive obligation," a contrivance that I don't have the stomach to deal with today.