Revenue Recognition: The Bottom Line on the New Top Line

Revenue — perhaps the most important number in financial statements — and how it is calculated by nearly every public company across the globe is set to change.

Today’s kerfuffle over General Electric’s choice of the retrospective method to adopt the new revenue recognition standard in 2018 — as disclosed in its 2017 Form 10K filed on Friday — demonstrates the importance of effective communication, both to the media and to investors, regarding the accounting standard change. Lacking a full understanding of the disclosure, many news outlets incorrectly implied GE was restating its financials because of an accounting error.

The new accounting standard governing the recognition and reporting of revenue under US Generally Accepted Accounting Principles (US GAAP) and International Financial Reporting Standards (IFRS) was issued in 2014, with the changes set to take effect in the first quarter of 2018.

How much change this new standard initiates will vary by company and industry, but every firm will be required to make additional, more-disaggregated disclosures. Further, the new standard replaces substantial prescriptive US GAAP guidance with principles that are highly, but not completely, converged with IFRS, which offered minimal guidance on revenue recogni­tion prior to this standard.

The new standard’s heightened use of judgment and estimates could affect earnings quality both at adoption and going forward. This along with the new disclosures on disaggregation of revenue are factors investors should pay attention to during the next several months as companies file their year-end 2017 financial statements and release their first-quarter earnings and financials.

Much of what has been written on the new standard has focused on how it should be applied by accountants and audited by auditors, not on how it should be interpreted by analysts and investors. To that end, in “Revenue Recognition: Top 10 Questions Investors Should Ask About the Adoption of The New Standard” we provide investors with our perspective on these considerations during the next few months. The questions addressed include:

1. Should investors expect a change in revenue recognition for all investee companies?
2. How is the investee company’s industry being affected?
3. What disclosure is the investee company making about the impact of adoption?
4. How are companies transitioning to the new guidance?
5. Is the revenue caption the only income statement line item change?
6. Will ratios be affected?
7. Will cash flow change?
8. Will valuation multiples change?
9. Will the company’s non-GAAP measures change?
10. Will any disclosures describe revenue and the change in revenue?

Consider Key Issues by Industry

While a handful of companies have early adopted, investors should develop their own expectations about the firms they follow or invest in as well as the nature of the changes in their respective industries. To that end, the paper considers the central factors driving change and some of the most significant issues by industry. We refer investors to earlier publications, where they can delve into greater detail on these matters, and to useful industry-specific content.

Adoption and Transition Disclosures

Although companies should already be disclosing the effect and method of adoption, research demonstrates that, as of third quarter 2017, they are not yet doing a very good job. With public companies completing the filing of their 2017 year-end financials, investors should start to see better disclosure on the standard change’s expected impact come the first quarter 2018. If the disclosures aren’t sufficiently robust, investors and analysts should discuss the effects with company management.

They also need to understand how firms are moving to the new standard. More companies have disclosed they will adopt the modified retrospective transition method rather than the fully retrospective method in which prior years are recast and presented under the new accounting standard. Our paper on revenue recognition considers how investors should analyze this modified retrospective method of adoption (i.e., opening adjustment to equity). Given the seasonality of earnings in some sectors, this method of adoption could impact quarter-to-quarter comparisons.

Today’s events with respect to GE only heighten the importance of asking and understanding the answers to these questions.

Financial Statements Effects: More Than Just Revenue

While headlines have focused on how accounting for revenue is changing, more than revenue may be revised thanks to the new revenue recognition standard. Costs associated with obtaining contracts with customers, taxes, and all key subtotals also may be adjusted. Investors and analysts need to consider all the financial statement effects and their related influence on key ratios that may drive key quant investing metrics, such as ROE.

Multiples, Cash Flows, and Valuations

The bottom-line question for investors and analysts: Does the adoption of the new standard impact valuations? More specifically, does it change cash flows and valuation multiples?

Cash flows should not be affected by adoption of the new standard — unless, of course, companies changed their contracts with customers in the lead up to the standard to achieve a desired accounting result. In future periods, should a company’s current taxes be based on book revenues, cash flows for taxes could be altered.

Theoretically, valuations should not require significant revision despite a change in operating income, net income, or EPS due to the transition to the new revenue standard. That said, investment strategies based upon book metrics — price-to-book, price-to-sales, ROE, EPS — may not step back and realize these changed metrics may distort the fact that cash is not changed.

Watch for Changes in Non-GAAP Measures

The new revenue recognition standard may also give rise to the creation by management of new or different non-GAAP measures that investors should evaluate. And that evaluation should extend not only to the nature of the new metric or adjustment, but also to the reasons why management deems such change necessary. This too can be an indication of earnings quality.

One of the most common non-GAAP metrics used as a proxy for cash flow — EBITDA — could change as well, even without a revision in underlying cash.

Disclosures: More Disaggregation

Whether or not the standard affects revenue, new incremental disclosures regarding the disaggregation of revenue will be useful to investors and analysts. The standard will require additional disclosures given the significant use of management judgment and estimates. Time will tell whether these will be informative or highly qualitative and boilerplate.

Most Interesting Developments May Be in the Future: Be Alert to Subjectivity

As 2018 results are disclosed, investment professionals should evaluate how firms have adopted and transitioned to this new stan­dard. Even if its impact on a particular firm is minimal, the change presents an opportunity to better understand a company’s contracts with customers, how it allocates revenue to per­formance obligations, and actually earns revenue. It also can help assess a firm’s earnings quality and future prospects.

The most interesting elements of the new standard may emerge as it evolves in the next several years. The degree of judgment and estimates the new standard allows companies to make is something to watch as is its potential effect on future earnings quality.

Moreover, since we understand some companies are behind in their adoption, investors should keep their eyes peeled for refinements over the next several years. As firms’ knowledge of the new standard increases and their visibility into the judgments and estimates of competitors expands, it will spur the emergence of new industry practices.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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