However, a more recent study by Donelson, Jennings, and McInnis (2011) in The Accounting Review sheds important light on these earlier findings. Donelson et al. examine individual expense lines to discover which line items are most responsible for the decline in the revenue-expense correlation over time. They disaggregate total expenses into cost of goods sold, SG&A expense, depreciation, taxes, other income/expenses, and special items. They find that the decline in the revenue-expense correlation over the past 40 years is primarily attributable to one line item—special items, which consists of asset impairments, restructuring charges, and gains/losses from asset sales. When the authors factor out the effect of special items, they find that the changes in the revenue-expense correlation are substantially reduced (as much as 90% in some cases). The authors go on to provide additional evidence suggesting that the cause of most special items is from changes in the incidence of underling economic events, and not from changes in accounting standards.

So why should this matter to financial reporting standard setters? For those who don’t agree with the idea that matching is an important concept in accounting, the results of these two studies are probably not that useful. But for those standard setters who may still hold on to traditional ideas on matching, and who may deplore any decline in matching over the years, these two studies suggest that new accounting standards have contributed very little to any decline in matching. Instead, it is the changes in the underlying economics of businesses that have caused any decline in matching. Standard setters probably wouldn’t want to undo financial reporting that actually captures changes in underlying economics, would they?

As an example, the practice of spreading the upfront costs of developing a new line of aircraft across the expected number of airplanes that will be built over the production run will continue under the new standard. This method of inventory accounting is often referred to as program accounting, but was never an officially approved Statement of Position. Instead, a draft SOP was created in 1981, and so many airline manufacturers began (or continued) following it that it became part of US GAAP because of its widespread use. Today, it is only referred to in passing as part of FASB ASC 912-20-25-5A. Still, it is widely used by airline manufacturers to defer large upfront development and so-called learning curve costs across the entire expected production run for a particular aircraft. (For a good description of this accounting, read the IASB Revenue Recognition Board Memos for May 31, 2011 covering this topic.)

Some will cry foul because they think many of these deferred costs are nothing more than accounting “watchamacallits” used to smooth earnings over time. But I wonder if the deferred costs (sometimes called know-how assets) aren’t simply a way of recognizing an intangible asset that standard setters are otherwise unwilling to recognize in other industries. If so, why do standard setters allow the recognition of this intangible asset for airline manufacturers, but are loathe to do so in other industries?

We may not be able to answer that question, but maybe as academics we can ask whether these know-how assets for airline manufacturers are predictive of or correlated with the value of the company. Is there prior research that examines how predictive of future cash flows these know-how assets are? How are market returns correlated with changes in the value of know-how assets? If there is not prior research, maybe some enterprising doctoral student or faculty member could look into this relationship and post some preliminary results.

My point here is not to criticize the boards’ decision not to pick up the issue of cost accounting as part of the revenue recognition project. Instead, I want to entertain the possibility that these deferred costs in the airline manufacturing industry are actually intangible assets worth reporting, even though many financial statement users probably understand that the underlying estimates are very subjective. These know-how assets likely provide decision useful information in that they are helpful in predicting the timing, amount, and uncertainty of future cash flows, and we as academics may be able to shed some light on that question. Any takers?

It was the unanimous view of the boards that while there was no formal due process requirement to re-expose the proposals it was appropriate to go beyond established due process given the importance of the revenue number to all companies and the need to take all possible steps to avoid unintended consequences.

The boards intend to re-expose their work in the third quarter with a 120 day comment period, which means that it is very unlikely that a final standard will be issued by December 2011, the most recently revised goal as of an April 21, 2011 press release.

I’m not sure how to react to this announcement. While I applaud the boards for their carefulness in seeking public comment on their work, I’m not sure what decisions need additional input. As some of my academic and practice colleagues have quipped lately, this new standard is turning out to be nothing more than all the old standards in new drag. Indeed, many of them have commented that although the proposed standard talks about things a little bit differently, almost all of the revenue recognition outcomes are the same.

I’m not sure I agree with my colleagues, but I can see their point. Perhaps in re-exposing their recent work, the boards should create a supplementary document that separately lists all of the outcomes that would actually be different from current practice, and what aspect(s) of the new model made that outcome different. I wonder how long that document would turn out to be.

One additional comment: My thoughts above about the outcomes of the new proposal not really being all that different from what we had before pertains mostly to US GAAP, but not to IFRS. Given the dearth of guidance on multiple elements (IAS 18, par. 13), I think the new proposal clearly improves existing IFRS. So, my comments above are largely focused on the changes (or lack thereof) to the outcomes in US GAAP.

 The exposure draft of an accounting standards update of codification topic 605 presents the following revenue recognition model (par. IN9):  (a) identify the contract(s) with a customer; (b) identify the separate performance obligations in the contract; (c) determine the transaction price; (d) allocate the transaction price to the separate performance obligations; and (e) recognize revenue when the entity satisfies each performance obligation.

 The exposure draft defines performance obligation as “an enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer (par. IN12),” and already this definition is the subject of debate. During the comment period ending in October 2010, this joint project with the IASB generated 986 comments, mostly from North America, but also widely distributed from around the world and from many industries. Based on those comments, the boards currently plan to modify the definition by excluding the word “enforceable” and adding the following sentence: “Performance obligations include promises that are implied by an entity’s business practices, published policies, or specific statements if those promises create a valid expectation of the customer that the entity will perform (April 26, 2011 update).”

 The proposed revenue recognition standard will perhaps have its biggest impact on the construction industry, as the “percentage of completion” terminology and technique will disappear. In order to apply accounting resulting in similar revenue recognition timing as the percentage of completion method, the construction company will have to argue that the contract with the customer represents a service contract with continuous transfer of the service (as opposed to a contract for the production and transfer of goods). “Continuous transfer of service” is still a developing concept; however, it appears that criteria such as the customer controlling the asset “as it is created or enhanced,” the contractor having the right to receive payment at various stages, or the customer having a reasonable expectation that it could fire the contractor at various stages and not need to have work done to date re-performed will meet the “continuous transfer of service” test.

 The proposed standard also potentially affects many industries in relation to accounting for warranties and to uncertainty around collection from the customer. Under the proposed rules, many warranties will be accounted for as separate performance obligations and the reduction of income will be accounted for as deferred revenue as opposed to accrued expense. Similarly, at the initiation of a contract estimates of the effects of customer credit risk will be accounted for in contra-revenue accounts as opposed to bad debt expense.

The boards also have on their agendas a phase of the conceptual framework project titled “elements and recognition.”  It will be interesting to see if/how the performance obligation concept affects the definition of a liability. As of March 2010, in deliberating about the definition of a liability in the elements and recognition phase of the conceptual framework project, the boards concluded that “it is unclear how the definition applies to contractual obligations.”

To stay current on the development of the new revenue recognition model, click here for the exposure draft, click here for an analysis of comment letters, and click here for decisions since analysis of the comment letters.

Jeff Wilks and I will periodically post entries regarding revenue recognition and we would be happy to orient those posts towards any questions or comments you may have about the developing “revenue from contracts with customers” standard. Please respond to anything we write, post your own revenue recognition-related FASRI blog, or send either one of us an email, and we will keep the posts moving in a direction that responds to the interests and concerns of the academic community and hopefully provides good soil for nurturing useful input to standard setters from research and other contributions of the academic community. Our email addresses are pbshane@fasb.org or phil.shane@virginia.edu, and wilks@byu.edu.

Although we heard this criticism often from some board members, this was not a common complaint from any other sources. I thought it was particularly noteworthy that we never heard such complaints from people actually working in the construction industry or analysts and investors in that industry. I’m not saying that some wouldn’t have agreed with this concern, but we so rarely heard complaints from preparers and users in that industry that I often wondered why this concern consumed so much of our staff time and seemed to motivate so much of the model we were creating.

To look into this a little bit more, I decided this morning to read through a few of the comment letters that have responded to the recent FASB/IASB exposure draft. The comment deadline is Oct. 22, so we can expect to see many more letters submitted in the next few weeks. But let me post a few excerpts from submitted letters that address concerns from the construction industry.

One letter is from Michael F. Greer, Vice-president of Surety and Fidelity of Penn National Insurance. Penn National provides surety bonds for construction companies, so they have extensive experience reviewing financial reports of construction companies and assessing the risk that a company will fulfill its contracts. Here’s some of what Mr. Greer has to say:

In our opinion, the new methods proposed are so unworkable, that it would be our company’s position that we would not accept a financial statement on this new method. So in order to obtain surety credit a contractor would have to have the CPA still provide us with a Percent complete basis statement, which may or may not be in accordance with GAAP under the new methods. The contractor’s Bank would more than likely require a GAAP basis statement. So in effect, the contractor will now have to pay for two sets of financial statements rather than one.

I understand that the goal of this effort was to create one unified method of accounting across various industries and countries. While that might be helpful to some industries, I suggest that a better alternative is that each Industry has a unified method of accounting. There needs to be recognition that there are major differences from one industry to the next. It does not make sense for every industry to have to be the same.

Most importantly however needs to be the recognition that the purpose of financial statements is to provide the users of the statements with information on which they can make decisions. If knowledge is lost just for the sake of having one set of rules, that would be a mistake and no one would be better off.

As you can see, Penn National Insurance company voices a strong opinion against modifying the requirements of POC accounting for the construction industry. He follows these statements up by asking the boards to scope construction contracts out of the proposed new standard.

Another letter, this one from David H. Rhodes and Steve Pate from Insco Insurance Services (also a provider of surety bonds to the construction industry), the authors highlight the longstanding and proven practices of POC accounting in SOP 81-1:

SOP 81-1 has provided a consistent standard of reporting revenue and income for construction contracts for almost three decades. It is a well established industry standard, and the percentage of completion method is imbedded [sic] in our company’s analytical approach, underwriting training, and information systems. We feel that the new standards proposed by the Board will lead to less consistency in revenue recognition under construction contracts, and could increase the opportunity for profits reported to be “managed” by selection of differing revenue recognition methods for different construction contracts underway for the same contractor.

Again we see a strong opinion that nothing is wrong with POC accounting. There are probably 10+ other letters (out of 35 so far submitted) from construction companies, many of the form letters expressing the same concerns. All of these make me wonder whether the proposed new standard should just leave well enough alone or whether the Boards and staff have been successful in educating construction industry constituents about how little would actually change under their proposed standard.

One final letter, this one from Allan Korsakov of Baker Concrete Construction, Inc.  In his letter, he forcefully argues:

In my reading of the Exposure Draft, the Boards came across are [sic] being rather dismissive of industry by industry nuances. Perhaps not enough consideration has been given to the validity of the “one-size-fits-all” approach. If one takes all the animals in the zoo and dresses them up in the same school uniform, they may all be animals, may all be in the same zoo and, so dressed, may all superficially bear a little more resemblance to one another, but they all remain uniquely different animals. We have to be careful to avoid mandating one size which fits none. We are not oblivious to the dangers of granting exceptions to individual industries. But from a practical point of view, we really don’t care how every other industry managers their business. Construction is a universal activity with many similarities in many different countries, but I would maintain that the construction industry is uniquely different from most other industries. The management of construction companies, their financial preparers, the users or [sic] their financial statements and even the accountants that audit them are all specialists in their field. The same is true from the perspective of many other industries as well. From a practical point of view, none of us really need to know how the other industries manage their affairs.

A few paragraphs later in the same letter, after describing in detail some of the complexities that are unique to the construction industry, Mr. Korsakov continues:

Given this greater level of complexity, we respectfully disagree that the stated goals of the Boards are best served by the cursory dismissal of the concerns expressed in the Construction Financial Management Association comment letter dated June 19, 2010. A few needed tweaks notwithstanding, SOP 81-1 works pretty darn well thank you very much.

So, who is complaining about POC accounting, and are the complaints important enough to warrant the significant changes that many in the construction industry expect from the newly proposed revenue standard?

Of course, with such a significant change, there are bound to be questions and concerns. Here are a few that have occurred to me.

1. One of the debates we had in the early days of this project was whether to define revenue, or just address how revenue should be recognized. As this exposure draft makes clear (see paragraphs 1-2), the boards ultimately decided not to define revenue, but instead only to address when revenue is recognized in contracts with customers. This made me wonder whether the boards will be happy with revenue being recognized in the absence of contracts with customers. Does revenue recognition require a customer? Apparently not. Revenue is recognized today for changes in the value of some mineral, biological or agricultural assets (IAS 41), even in the absence of a contract with customers. Why do we get a difference for revenue recognition principles across various industries or types of assets? The proposed new standard scopes out non-contractual situations (such as biological and agricultural assets) as well as contractual situations (such as leases, insurance, financial instruments, and guarantees). Conspicuously absent from the exposure draft is any rationale for scoping these areas out of the proposed standard. From experience working on this project, I’m guessing that’s because there was no general agreement about WHY these would be scoped out. There is simply a consensus that they should be scoped out. Wouldn’t it be great if the boards could provide some rationale for scoping out particular types of transactions?
2. The exposure draft states that an entity shall account for each promised good or service as a separate performance obligation only if that good or service is distinct (see paragraph 22). A good or service is distinct if either (a) an entity  sells an identical or similar good or service separately, or (b) the entity could sell the good or service separately because (i) it has a distinct function AND (ii) it has a distinct profit margin. My question–how do you know whether something has a distinct profit margin unless you (or someone else) actually sell that something separately? And if you already sell it separately, then there’s no need for condition (b). The exposure draft states that a distinct profit margin exists if that good or service is subject to distinct risks and the entity can separately identify the resources needed to provide the good or service. This is one area of the proposed new standard that I think people may have some difficulty with—determining whether a potentially separate good or service has distinct risks. If there’s anything our recent past has taught us, it’s that people are pretty bad at identifying and quantifying risks. Who knows, perhaps it won’t be so hard to do for revenue recognition purposes! (By the way, don’t misinterpret my tone here…I actually like the direction the boards have gone with this guidance, but I think it will be a little perplexing at first.)
3. Determining the transaction price in a contract receives lots of attention in the exposure draft. The boards decided that the transaction price should be adjusted based on the time value of money (if financing is a significant component of the arrangement), customer creditworthiness, collectibility, any non-cash consideration received from the customer, and any consideration payable to the customer (such as rebates). I don’t really have a question here, but I do want to highlight how this will be a significant departure from past practice in some situations. Previously, revenue would not be recognized in some situations if certain criteria were not met, for example in real estate sales. If the criteria were met, revenue for the full contract amount would be recognized. Instead of asking whether to recognize revenue, this standard moves more toward asking how much revenue to recognize. So, for instance, if you have sufficient history selling real estate to particular classes of customers, and your history suggests to you that 60% of the time customers follow through with their promises to pay over time, then either through discounting with a high interest rate or through an adjustment due to collectibility, you would recognize the sale of real estate at a drastically reduced amount. Any amount received beyond the original revenue recognized would be treated as a gain or loss. Personally, I think this is an improvement over the criteria approach, but it has its own problems as well, including the estimation process required to determine the amount of revenue to recognize in such a sale.

I’ll stop here for now. I still want to go through the application guidance with a finer tooth comb, but I’m pretty impressed with most of what I’ve read. As much as the project was originally conceived to be a general standard on revenue to replace all other revenue standards, I think the boards have appropriately scaled back their ambitions to focus strictly on settings where a contract with a customer exists. This represents the lion’s share of situations in which revenue is recognized today, and the proposed new guidance will not change most accounting out there. However, what it does change could be pretty significant—including construction contracts, real estate sales, and software revenue recognition. I look forward to reading the comment letters over the next few months!

In summary, the core principle [of revenue recognition] would require an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services.

To apply that principle, an entity would:

(a) identify the contract(s) with a customer;

(b) identify the separate performance obligations in the contract;

(c) determine the transaction price;

(d) allocate the transaction price to the separate performance obligations; and

(e) recognize revenue when the entity satisfies each performance obligation.

I haven’t had a chance to look and see if there are many surprises.  For now, let me just remind readers of the new terminology under the Accounting Standards Codification (ASC).  This document is a Proposed Accounting Standards Update (ASU), and when it is approved, it will substantially modify Topic 605 of the ASC, which covers revenue recognition.  But it will also make changes to a host of other Topics — read ‘em and weep!

? 340-20 Other Assets and Deferred Costs—Capitalized Advertising Costs

? 360-20 Property, Plant, and Equipment—Real Estate Sales

? 430-10 Deferred Revenue—Overall

? 470-40 Debt—Product Financing Arrangements

? 605-15 Revenue Recognition—Products

? 605-20 Revenue Recognition—Services

? 605-25 Revenue Recognition—Multiple-Element Arrangements

? 605-28 Revenue Recognition—Milestone Method

? 605-30 Revenue Recognition—Rights to Use

? 605-35 Revenue Recognition—Construction-Type and Production-Type Contracts

? 605-45 Revenue Recognition—Principal Agent Considerations

? 908-605 Airlines—Revenue Recognition

? 910-605 Contractors—Construction—Revenue Recognition

? 912-210 Contractors—Federal Government—Balance Sheet

? 912-275 Contractors—Federal Government—Risks and Uncertainties

? 912-605 Contractors—Federal Government—Revenue Recognition

? 915-605 Development Stage Entities—Revenue Recognition

? 922-430 Entertainment—Cable Television—Deferred Revenue

? 926-430 Entertainment—Films—Deferred Revenue

? 926-605 Entertainment—Films—Revenue Recognition

? 926-845 Entertainment—Films—Nonmonetary Transactions

? 928-430 Entertainment—Music—Deferred Revenue

? 928-605 Entertainment—Music—Revenue Recognition

? 932-605 Extractive Activities—Oil and Gas—Revenue Recognition

? 940-605 Financial Services—Brokers and Dealers—Revenue Recognition

948-605 Financial Services—Mortgage Banking—Revenue Recognition

? 952-340 Franchisors—Other Assets and Deferred Costs

? 952-605 Franchisors—Revenue Recognition

? 952-720 Franchisors—Other Expenses

? 954-430 Health Care Entities—Deferred Revenue

? 970-605 Real Estate—General—Revenue Recognition

? 972-430 Real Estate—Common Interest Realty Associations—Deferred Revenue

? 972-605 Real Estate—Common Interest Realty Associations—Revenue Recognition

? 974-605 Real Estate—Real Estate Investment Trusts—Revenue Recognition

? 976-310 Real Estate—Retail Land—Receivables

? 976-605 Real Estate—Retail Land—Revenue Recognition

? 978-310 Real Estate—Time-Sharing Activities—Receivables

? 978-340 Real Estate—Time-Sharing Activities—Other Assets and Deferred Costs

? 978-605 Real Estate—Time-Sharing Activities—Revenue Recognition

? 980-605 Regulated Operations—Revenue Recognition

? 985-605 Software—Revenue Recognition

Also, keep in mind that if this is passed, no one will ever refer to the particular ASU the way we do SFAS 13 or SFAS 157.  Instead, we simply have a revised codification.

“June 30, 2011, is an arbitrary deadline and it’s not one that’s been put in place by the SEC or by our road map,” said Kroeker. Citing FIN 46(R) as an example of an accelerated project that later needed to be reworked, Kroeker said that what’s most important is to ensure through the exposure process that the final standards are a “long term, sustainable solution.”

I suspect the FASB is not all that surprised by Kroeker’s view, given how good the lines of communication typically are between the FASB and the SEC. However, I suspect the IASB and other supporters of a single, global accounting standard will be a little surprised and will interpret Kroeker’s comments as (further) evidence that the US will not be adopting IFRS any time in the near future. They may even increase the volume on their arguments that the IASB should not give so much preferential treatment to the FASB and SEC in its standard setting activities. Should make for some interesting articles over the next few weeks!