Changing revenue rules: A business perspective
With 2018 now upon us, your company's board has probably already approved budgets and sales forecast for the year, hoping it will be a good one. Well, it may not be—and through no fault of your own.
From January 1, the accounting rules on revenue recognition from contracts with customers are changing. What this may mean for your business is that despite cash coming into your company’s bank account, your bottom line may be smaller than ever, leaving your investors craving for more.
You can thus hope that your finance team has taken this into account while preparing any forecasts. But have they actually? A study conducted by EY in late 2017 determined that only 1 percent of Fortune 500 IFRS financial statement preparers provided quantitative information about the expected effects of this change. Probabilistically speaking you are not ready, so let’s take a look at what is in store for your company’s revenue profile.
The mechanism of change: who will suffer the most?
The change of accounting rules affects those who have long-term contracts with their customers. Up until now, the standard allowed companies to recognize revenue and costs over time as the contract was being performed. With the new rules, you will need to scrutinize the structure of your contracts to identify “performance obligations,” i.e., any parts to the contract that can be used separately by your client. Only once these separate goods or services are delivered, your company’s revenue will increase.
In other words, what the new standard is doing is altering your revenue pattern. Your sales figures will now become “lumpy,” with the trends experiencing month-on-month or even year-on-year peaks and troughs. High volatility of revenues may cause your current shareholders and potential investors to question your ability to run your business, thus calling for a new and improved approach to strategic planning.
There are various industries that will suffer most from this change, including automotive, telecommunications, construction, engineering, pharmaceuticals, aerospace and defense—the list is neverending. In general, any IFRS or U.S. GAAP reporting entity with contracts with customers spanning over one year in duration need to prepare for the changes to their revenue patterns.
Accounting vs. business objectives
Your company may have many objectives stated in your annual report, but generating revenue is by far the most important one. The change of revenue rules will therefore affect not only your finance team and shareholder-investor relations, but also all of your business functions and capabilities.
Lower revenues will impact your ability to meet the agreed upon KPIs. This will trickle down to any employees whose performance is measured by revenue targets. It is therefore time to ask: Is your sales team ready for this? Are any of your employees’ bonuses tied to the turnover of your company? And finally, what changes to the structure of your business are needed to differentiate top performers from the weakest links?
There is no doubt that the change in accounting rules will also affect your finance team. The new revenue standard is a complex one, introducing a new model, multiple additional disclosures and various practical expedients to be studied. What this implies is that training regarding the new practice will be required in 2018.
The way forward
How to prepare your business for the new rules? The key is communication. Organizing a series of workshops with your key teams—finance, legal, sales and procurement—would allow your employees to understand these changes and come up with strategies. This will have to be a joint effort as John from sales may not realize the accounting impact of the revenue standard whilst Linda from finance may not be aware of the structure of your contracts.
Another way to start would be to analyze the structure of your contracts. Ask your staff the following key questions. First, how many separate “performance obligations” can you note? If there is a lot of those within a contract, with a small amount of time between them, your revenue stream may not change drastically. However, if there is only one distinct good or service provided, you may have to recognize revenue only when it is delivered. Secondly, do your contracts contain a clause of enforceable right to payment for your work to date? If so, you may still be able to record project revenue over time. However, if they don’t, your turnover is likely to be recorded only when the contract is finalised.
Educating your shareholders and potential investors about the impact of the change is another stepping stone. They need to understand that the irregular revenue patterns are a direct result of the change in the accounting rules, not your incompetence. Qualitative disclosures in your annual financial statements could be a good way forward.
Finally, hiring an external expert to guide you through the changes can save you a lot of trouble. Large accountancy firms offer transition deals, including training and help with the implementation of the new rules. Alternatively, the market is full of revenue recognition consultants, ready to lend a helpful hand for a salary starting from $60,000 per year.
The change of the accounting rules usually implies more work for the finance team. But when the change affects revenue, your whole business needs to mobilize. Understanding the change and forming a plan of action should be the first things to do after you are back from your winter holidays.