Modeling Revenue Recognition for Contracts to Meet New Regulations


I recently wrote about the challenge some companies will face in planning and budgeting when new revenue recognition rules go into effect in most countries in 2018. It’s important for companies that will be affected to be sure they have the appropriate systems, processes and training to handle the more difficult demands imposed by the new rules. With the change in accounting, the time lag between when a contract is signed and when a company recognizes revenue from it may be more variable and less predictable than in the past. In extreme cases, performance measured by financial accounting will diverge materially from the “real” economic performance of the organization. Consequently, executives – especially those leading publicly listed companies – will need the ability to look at their plans from both perspectives and be able to distinguish between the two in assessing their company’s performance. In companies where the timing of revenue recognition can diverge substantially from current methods, financial planning and analysis (FP&A) groups will need to be able plan using models that incorporate financial and managerial accounting methods in parallel. They will need to be able to identify actual-to-plan variances caused by differences in contract values booked in a period and differences between the expected and actual timing of revenue recognized from contracts signed in a period.

I don’t want to overemphasize the impact the new revenue recognition rules will have on companies’ planning. While some companies need to understand that they will have to alter their planning and review processes, I expect that most will be unaffected by the new accounting for contracts, for at least one of three reasons:

  • A majority of their revenue does not come from contracts. (Retailing is one industry in which many companies do not transact business using contracts.)
  • No single contract or type of contract is large enough to have a material impact on reported revenue.
  • The time lag between signing a contract and fulfilling the contract is short (a month or less) or the time lag between booking a contract and fulfilling it is reliably consistent from month to month or quarter to quarter.

For many companies, tracking individual contracts will be unnecessary, impractical or both. It may be unnecessary because the relative size of contracts matters. Even if an organization’s individual contracts differ significantly in terms of the interval between signing it and recognizing revenue from the transaction, if there are enough of and even the largest represents an insignificant percentage of total revenue, the difference won’t matter. That is, in most cases the difference between expected and actual timing of revenue recognition of individual contracts is likely to be cancelled out. Moreover, tracking individual contracts will be impractical for many organizations because their volume will make it is too expensive and time-consuming to capture the relevant terms and conditions for each contract, which is necessary to be able to isolate the factors driving actual to forecast or budget variances. For FP&A groups the challenge will be in creating models that accurately forecast the average lag between contract signing and when revenue is recognized. Analysts also should confirm that the standard deviation of this lag under the new rules will be small enough to avoid the need to segment contracts into major types. (I’ll return to this point shortly.)

Nonetheless, a significant number of organizations – either entire corporations or business units with revenue responsibility – will need to change their approaches to creating and using planning models in order to accurately measure variances between their plans or budgets and their actual results. This means developing models that enable them to separate variances that are the result of differences in when business was booked and those in which the timing of the revenue recognition process turned out to be longer or shorter than expected. Certain types of businesses that have large, complex contracts with their customers, such as aerospace, construction and engineering, are likely to find that they need to plan and track results by contract – at the very least the 20 percent of their contracts that account for 80 percent of their revenues.

Another type of company or business unit that will need to adopt a more granular approach to tracking contracts  under the new rules is one in which there are significant differences between the timing of revenue recognition for different types of contracts. Even though the value of individual contracts booked in a period is an insignificant percentage of the total, it may be necessary for organizations to segment contract bookings and revenue recognized for each major type of contract. This would be the case if there are significant differences in the timing of revenue between types of contracts and the mix of contract types varies from one month to the next. For example, imagine that Company X has contracts that have three distinct revenue recognition profiles. In one of them, which accounts for one-quarter of annual bookings, there is a consistent one-month interval between when the contract is signed and when revenue is recognized. For a second type of contract (representing 40 percent of annual bookings) it can take up to several months before revenue can be recognized, and then it happens all at once. The remaining contracts are recognized over a year after a contract is signed. Any significant differences in the mix of contract types signed from month to month will make it difficult to reconcile variances and accurately identify differences caused by better than expected or inadequate contract bookings and those caused by timing differences.  So it’s necessary to create and use models that segment revenue by mix of contract types.

It is time for companies to get serious about adapting their business to the new revenue recognition rules. They will have to cut over to new processes and systems in 2017 to comply with the new standards and be able to make year-on-year comparisons when the new methods go into effect in 2018. Financial planning and analysis groups should be considering whether their forecasting, planning, budgeting and reporting models and processes will need to change under the new accounting standards. Those that will have to change should look into acquiring a dedicated planning and budgeting application if they (or affected business units) are currently using spreadsheets for planning. That will include many organizations: Our next-generation business planning research vr_NGBP_09_spreadsheets_dominant_in_planning_softwarefinds that two-thirds (65%) of companies use spreadsheets to manage their budget process. A dedicated planning application will help them prepare better to understand whether a difference was due to the new accounting rules or poor performance using actual data rather than opinions.

FP&A groups should be aware of their company’s exposure to new revenue recognition rules. If the rules will have a material impact on how the company accounts for contracts, they should determine whether it will be necessary to plan and budget for “real” and accounting data in parallel. If so, and if their company currently plans and budgets using desktop spreadsheets, I strongly recommend that they look into acquiring a dedicated planning application. In addition to dealing with increased complexity, this type of software can improve the budgeting and planning processes, making them more efficient.

Regards,

Robert Kugel

Senior Vice President Research

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