Ahead of the Accounting Curve, Too

Technology giant Apple has benefited from its early adoption of new revenue-recognition rules. But for other companies, the rules could present some challenges.

The rule change “allows companies to follow more of the substance of the transaction,” says Kelley Wall, senior consultant at accounting and financial advisory firm RoseRyan. “Now you can match up the elements of what you are delivering to an estimated value.”

In its fiscal first quarter, which ended December 26, Apple recorded total revenues of $15.68 billion and a net profit of $3.38 billion, compared with $11.88 billion and $2.26 billion for the same period in FY 2009. Some of the 2010 revenue can be attributed to the accelerated revenue-recognition brought on by the new rule, a transitional boost Apple is required to explain in its financial-statement footnotes. Indeed, under old rules, a natural “smoothing” of revenue took place because recognition was spread out over the life of bundled products, says Wall.

Wall notes that Apple provided three years of “great” comparative data and reconciliations to explain the changes. But she adds that companies usually find it “very challenging” to adopt rules retrospectively, “and it is my guess most companies will not do so.”

In addition to accelerating revenue recognition, there may be some instances when the new rule promotes new sales, says Wall. Consider that companies will be able to develop and release more-robust product road maps, which can be touted by the sales staff without triggering the deferral of substantial revenue recognition. “Accounting road blocks won’t exist anymore,” she says, and that could lead to an increase in product sales.

Challenges Ahead, Plus an ERP Problem

Despite the additional flexibility companies will gain by adopting the rules, management will face some nonaccounting challenges. For example, sales-commission structures may have to be reworked, because the accelerated recognition of revenue will front-load payouts to the sales staff, which could disrupt budgeting and forecasting exercises. That front-loading effect could also create more volatility in earnings, says Wall, referring to the absence of the “smoothing” effect that subscription accounting creates.

Earnings volatility also could cause companies to rethink earnings guidance, perhaps pushing them to quit the guidance game altogether. What’s more, managers will have to tread lightly when educating investors and analysts about the impact of the rule so as not to violate fair-disclosure rules. That is, says Wall, the investor-relations team must avoid getting too specific about comparable financial-statement data when explaining the new recognition timing, unless they release those details publicly.

Accounting software embedded in enterprise resource planning systems may also create pockets of havoc. Reportedly, some ERP systems cannot incorporate the relative-value method of allocation used to defer the revenue associated with each product component. Say, for instance, that a company sells a bundled product for $100, and it includes hardware, software, and a year-long service contract. Under the old rules, if the selling price of the three components cannot be calculated, then the entire $100 must be recognized using subscription accounting over the life of the product. ERP systems work fine in this situation, which calls for a specified dollar amount to be allocated over a certain time frame.

But the new rules throw a virtual wrench into the system. In the case of the $100 product, companies will estimate the value of each component and spread the revenue proportionately by percentage allocation to the various elements. That’s where ERP systems stumble, says Wall. The systems are not programmed to use the bundled price as a starting point and then break down the allocations on a percentage basis.

Last year Tivo Inc.’s corporate controller, Pavel Kovar, addressed the ERP problem in a comment letter on the new rules. “Requiring solely the relative-selling price method is not operational,” wrote Kovar, adding that using that method “will require significant and costly redesigns of accounting software which currently allow for deferral of the full fair value of undelivered elements.” Kovar said the company was also concerned about whether or not accounting-software packages would be able to simultaneously handle recognition of deferred revenue from legacy arrangements and from arrangements under the new rules.

According to Wall, accounting and IT managers are currently discussing how to approach the ERP problem, with some smaller companies suggesting the use of spreadsheets to calculate the relative value of unbundled components. In that way, the spreadsheet calculations could be fed back into the ERP system to capture the proper revenue-recognition allocations. As for larger companies, Wall says those managers are tinkering with software fixes that will allow for the new revenue-recognition calculations to be fed directly into their existing ERP systems.

 

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