When is a sale a sale? That seems an easy enough question, but it is, in fact, one of the thorniest issues in corporate accounting. It is also one that standard setters may soon weigh in on, with a new policy that could force sweeping changes in the financial statements of U.S. corporations.
The policymakers at the Financial Accounting Standards Board, which is expected to issue a preliminary draft of a new revenue-recognition standard before year-end, have their sights trained on an important target. Revenue is the largest entry in most companies' financial reports, and it's the line item most often involved in accounting errors and fraud. Of the 919 financial restatements made by U.S. public companies between the beginning of 1997 and June 2002, 38 percent involved the improper recognition of revenue, according to a 2002 Government Accountability Office report.
"Revenue affects everything on the income statement," says Tony Sondhi, a financial reporting consultant and a member of FASB's Emerging Issues Task Force. "No matter how you look at it, it's a critical component of financial reporting."
An overhaul of the standards is long overdue. There are now more than 180 rules and interpretations that govern revenue recognition, from FASB, the Securities and Exchange Commission, the American Institute of Certified Public Accountants and earlier standard-setting bodies. Many are industry-specific. As they've multiplied, the comparability of financial reporting across sectors has suffered.
"A general standard on revenue recognition would probably be the most important thing FASB has produced since it was founded" in 1973, suggests Michael Tovey, the FASB project manager overseeing the proposal.
It will almost certainly be one of the most contentious. That's because FASB is likely to abandon the current method of accounting for sales, in which companies record specific sums that are payable in return for the delivery of goods and services, in favor of a new approach that derives revenue from changes in asset levels on companies' balance sheets. Rather than totaling the proceeds of individual sales, companies would arrive at top-line numbers by comparing assets at the end of a given quarter with the previous quarter's level. The difference would represent that quarter's revenues.
One rationale for such a huge departure is that the new method would make it harder for companies to fudge numbers by booking revenue before it is realized. But such a standard would also depend on companies' making accurate -- and almost certainly more complicated -- valuations of their assets.
"It's a very different way of thinking about revenue," says Dennis Beresford, a former FASB chairman who teaches accounting at the University of Georgia. "I don't favor it at this point."
Companies that bundle products and services together or enter into long-term contracts with complex performance obligations will be most affected, because the assets resulting from these deals are more difficult to value than those from simpler ones. Software makers, energy companies, broadcasters and real estate developers all could see their accounting practices made more complex.
It's too early in FASB's slow-moving process to say how such companies' earnings might be affected. What's certain, however, is that any new standard will be a tough sell. Financial executives are already bleary-eyed from implementing financial reporting changes related to the Sarbanes-Oxley Act of 2002. The last thing they want now is another policy edict that complicates their lives further and alters corporate earnings.
"It is important that a new standard provide information that is more useful to users of financial statements in making business and economic decisions," says Bob Laux, director of technical accounting and reporting at Microsoft Corp., of the FASB project.
"There will be economic consequences, and there will be complaints," predicts consultant Sondhi. "There always are."
Hard to recognize
Accounting regulators are about to overhaul the standards regarding revenue recognition, which plays a role in many restatements of corporate earnings. Below are several examples of recent restatements triggered, at least in part, by revenue-recognition issues.
Size of restatement*
Source: Company reports.