Peeling away financial reporting issues one layer at a time

Revenue by (Logical) Deduction

It seems there is always good reason to write a post about revenue recognition.  I can even envisage an entire blog on  the FASB’s new standard (ASC 606). It could go on for years without running out of fresh material.

That said, two thoughts — one general, and one specific — are behind this post.  The general thought I want to share is that the impending initial implementation deadline of ASC 606 is still being greeted with deafening silence.

I hear absolutely nothing from users of financial statements, the putative beneficiaries of a new standard.  Perhaps, it is because nothing much will change output-wise.  I have long suspected that the FASB had, years ago, chosen out of political expediency (survival?) to constrain itself to new rules that would only keep  the timing of revenue and earnings where it is, or to accelerate it. Recently, an FASB insider, without any prompting from me, confirmed this.

As to where issuers stand, there are tremendous implementation costs to ASC 606.  Yet, issuers have been largely indifferent because it doesn’t affect them (i.e., CEOs) directly — as distinct from their shareholders who ultimately bear the implementation costs.   I recently viewed a free webcast presented by one of the Big Four on implementing ASC 606.  Only 5% of the attendees that had familiarity with their company’s adoption progress indicated during the webcast that they planned to adopt early — a good indication of how few will welcome how the new standard will affect their earnings.  And, by the way, that’s not just speculation on my part.  I asked that question of a national office staff member of another Big Four firm, and that’s the answer I received.

The webcast survey also revealed that 58% are still only in the early stages of getting ready for the changeover.   I don’t know how many companies were represented, their characteristics, or even the number of respondents.  But, any way you look at it, there seems to be a lot of procrastination going on.  (There are also, by the way, a lot of consultants and IT providers looking for a piece of the systems churn.)

* * * * * * *

That’s my general thought.  My narrower thinking pertains to Proposed ASU EITF-16C, Service Concession Arrangements (Topic 853): Determining the Customer of the Operation Services.  I expect that not many readers will find this item compelling in its own right.  However, the FASB’s approach is an apt illustration of the struggles (ASC 606 has been 15 years in the making!) to create guiding principles for revenue recognition.

The arrangements that are specifically addressed by the proposed ASU are between a public-sector entity (the grantor) and an operating entity.  The operating entity is paid a fee to manage the use of the grantor’s assets (“infrastructure”).  At first blush, this doesn’t appear to be much different than arrangements between two private sector entities — e.g., between the private owner of a hotel and a hotel operating company.  A critical differences that seems to merit a separate accounting rule is that the operating entity’s right of use of the underlying infrastructure asset is more restricted:  the grantor has the ability to modify or approve the services that the operating entity must provide, and to determine the prices of the services to be provided.

Accordingly, the FASB is proposing that an arrangement within the scope of the proposed ASU would not be accounted for as a lease by the operating company (even though it has acquired a right of use); and the basis for recognizing revenue (under either current GAAP or impending ASC 606) would suppose that the grantor, and not the end user, is the customer.  Under current GAAP (and IFRS for that matter), a private operator could regard either the end user or the grantor as the customer.

The implications of the proposal relate to presentation of revenue — gross or net of operating costs — as well as timing.   It is not unlike the hundreds of the other scenarios that the FASB has wrestled with over the decades.  Yet, the root cause of all the back and forth deliberations between one so-so solution and another  is surprisingly simple.

We’re talking Accounting 101.  It is well recognized, that there are three core elements to financial statements:  assets, liabilities, and equities.  It has also been long accepted, and enshrined for decades in the FASB’s conceptual framework that assets and liabilities should be independently defined; and equities should be defined as assets minus liabilities.  For to define equities independent of assets and liabilities is a crime against the rules of addition and subtraction.  (In mathematics, a system is overdetermined if there are more equations than unknowns.)

Now, let’s extend the same logic to the statement of comprehensive income.  CI is defined by the framework as the change in owners’ equity arising from transactions with non-owners.  Further, we can look at the statement of CI in the same basic way way that we look at the balance sheet:

Revenues – Expenses – Losses + Gains + OCI = CI

And, just as for the balance sheet, the FASB cannot independently define each and every one of the components of the statement of comprehensive income without violating mathematical logic.  Yet, that’s what it does!

To illustrate the problem, if proposed ASU EITF 16-C specifies a manner for measuring revenues such that it is not a residual in the comprehensive income equation, then some other accounting element has to give.   Either the FASB has to (implicitly or explicitly) fudge one of the other components of CI; or, more commonly, sanction a bogus asset/liability.

That, blessed children, is the way the FASB’s (and IASB’s) conceptual framework actually is written.  More than any other reason, it is why U.S. GAAP can’t possibly amount to anything more than an overly-complicated sack of mush.

Many fixes are possible, and I will now propose what I think is the best one:  deduce revenues from the other, independently-defined components of the statement of comprehensive income:

CI + Expenses + Losses – Gains – OCI = Revenues

Of course, that won’t happen.  The FASB will for the foreseeable future continue running around in circles while blithely ignoring that the mathematical foundation of its conceptual framework is flat out wrong.  Effectively, double-entry accounting as a logical basis for financial statements is given mere lip service.

But why?

The FASB’s primary stakeholders are not investors; they are the executives of issuers.  These are the folks who historically funded the FASB and continue to dominate its oversight board, the Financial Accounting Foundation.  These folks need, above any other component of financial reporting, to control the measurement of revenues. It doesn’t sit well at all to have revenue be a residual — even if that could be the only practicable and logical basis for income statement presentation.

The emperor has no clothes.


  1. Reply Keith Mautner January 18, 2017

    How do you (independently) determine comprehensive income without a revenue component?

    • Reply Tom Selling January 18, 2017

      Hi, Keith. CI is defined in the concepts statements independently from revenue as the change to owners equity due to transactions with non-owners. In other words, you can measure CI without having to prepare a statement of comprehensive income.

  2. Reply Jeff October 21, 2017

    This is a extremely in-depth and academic article I really appreciate your contribution. Most of the blog posts I read are much more mundane and written can the common vernacular.

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