The accounting and auditing field has changed enormously over the last ten years. Due to evolution in business and accelerating globalization, the number and complexity of accounting and disclosure rules have increased markedly. Generally, these rules, which were intended for the "public good" and to promote comparability of financial results, have become a thorn in the side of many finance and accounting professionals. Nowhere is this more obvious than in revenue recognition rules as they have evolved for U.S. GAAP accounting.
Principles-based accounting left much open to interpretation by creative accountants, so more, newer, complex rules were forced upon an already difficult field, which had little automation support. Ultimately, the finance department handles most rules manually, and these are more subjective than before.
With recent guidance from the Securities and Exchange Commission to align with IFRS requirements in the future, accountants and organization management are dealing with a level of uncertainty again in revenue recognition requirements.1 Unfortunately, from our experience it seems that company management has become so engrossed in trying to interpret and execute the rules that they seem to be missing the broader opportunity that has presented itself around revenue recognition and accounting.
Companies struggling with complex revenue recognition rules are not realizing what some industries understood many years ago: that they should modify sales techniques to deliver the appropriate financial results, in the right period, based upon the results and performance of the contracts that have been sold. While "managing" revenue has a bad sound and feel that harkens back to the late 1980s and even to the dot-com bubble, managing "deferred revenue" is well within every company's capabilities and rights. In fact, it is one of the most effective ways to make overall revenue growth more predictable, thereby boosting investor confidence in future performance and increasing value.With business contracts, some contract clauses and business situations lead to the deferral of revenue. Revenue deferral should be part of the contracting, business planning, and forecasting cycle vs. its current status as a mere afterthought. Unfortunately, most companies focus on managing "sales," "revenue assurance," and the "pipeline," not on how a backlog in revenue -- deferred revenue -- can affect short-term earnings and longer-term returns for the company.
By understanding revenue accounting rules, organizations can better deliver on business results by:
Stocking up for the long haul;
Improving business performance;
Enhancing product features; and
Supporting strategic decisions with "fair value"
Stocking Up for the Long Haul
Proactively, companies need to combine products and services in a way that intentionally creates deferred revenue. While seemingly counterintuitive in a market environment that is looking for instant gratification and continuous return improvement, doing so is critical in periods such as the current economic difficulties. Every marathon runner knows that loading up on carbohydrates and managing their "energy store" before the race are critical to making it through the distance, even though there are opportunities along the way to recharge during the race.
Most organizations look at business operations as a series of sprints, burning too much fuel early in the cycle and not leaving enough for the inevitable dips along the way. Ultimately, this manifests itself in a "good revenue vs. bad revenue" environment -- too much short-term benefit is basically bad revenue, putting the organization at risk for a potential product/service launch that does not succeed and causes a reversal in growth.
In the short run, organizations will struggle with compensation strategies that often focus on revenue and margins. However, with the right transformation, most profit-driven enterprises can adapt to focus on sales and unit movement, leaving revenue in a dual stream -- current sales that provide immediate revenue conversion and the conversion of deferred revenue into current revenue as new conditions are met.
Few companies can see the challenge prior to product launches. In the case of Apple and its recent 3G iPhone launch, its business managers identified future upgrades to the iPhone software as critical to the purchase, allowing them to defer the revenue. Since these software upgrades were offered at no charge, the entire purchase amount of the iPhone was deferred over the service term.2 By doing so, Apple as a product sales company can report a smoother revenue curve that would otherwise include big spikes with each new product release cycle. None of what Apple did was inappropriate; on the contrary, Apple shows how a mature, astute organization can use revenue accounting rules to its benefit.
Improving Business Performance
Revenue deferral is not always caused by the application of complex revenue accounting rules; sometimes it is a result of simple operational realities -- billing in advance of services. We find that organizations do not exploit the effect of relatively simple adjustments to billing practices to boost the financial performance of the organization.
Case in point: Most consumers are comfortable paying for services in advance of provisioning -- cable, phone, and insurance. However, only for insurance are we using a 6-month or even annual billing cycle. Insurance companies defer the revenue over the period of coverage. But they also have the premiums to support investments and pay for claims. The churn/defection rates for insurance companies are surprisingly low -- while this is not necessarily attributable to the billing frequency/cycle, we feel that the infrequent nature of the billing helps clients to "forget."
Few industries or companies have moved to a lower-frequency billing environment than has the insurance industry. Reduced billing affects financial results by reducing:
Operational costs of billing and collection;
Customer churn and cost of customer acquisition;
Investment and capital carrying costs; and
Cost to customers
Cable television and telephone services are only some of the industries that can benefit from taking a page from the insurance industry's playbook. While the risk of customer defections in a "lumpy" billing model is real, most finance professionals can see the value of the reduced number of billing statements and the lowered billing costs under the prepayment model.
The transformation has already started, with companies such as Lingo (i.e., the Voice Over Internet Protocol computer telephony division of Primus Telecommunications), which offers the Talk 365 plan with an annual billing cycle.3 Another similar industry is airlines, which offer ticket packs in advance, a common practice in commuter flight environments.
Companies try to lock up customers using extended contracts or rewards programs. However, they are still challenged because:
They are only managing churn and customer acquisition and not the other metrics that affect business performance.
Deferred revenue is sometimes created in the parts of the sale where deferrals are not desirable.
Eventually, each organization has to define its value levers. Some customers may be willing to pay 10 to 15 percent less in a periodic billing model, while the service provider can save up to 30 percent in operational costs and deliver more reliable results to Wall Street -- a 15 to 20 percent margin opportunity that can be hard to pass up.
Enhancing Product Features
Particularly burdensome for those struggling with revenue recognition rules are revenue splits between products and services when they have been offered as bundles. This is called establishing the fair value (FV) or vendor-specific objective evidence (VSOE) for the deferral of revenue.
Emerging Issues Task Force (EITF) 00-21 requires that the FV of each element be present to separate the various elements for revenue recognition. EITF 00-21 allows a company to look to the marketplace and other entities that sell the elements in developing FV. VSOE of FV is prescribed by Statement of Position (SOP) 97-2. For software sales, it requires that companies have sufficient support for the separate elements of a software arrangement in the market on a stand-alone basis. For VSOE, what other companies in your space charge for the same elements is not relevant; only what your company charges is relevant.
Ultimately, the FV assessment and timing of delivery define the "revenue profile" for the transaction.
However, only the more astute organizations have started to leverage the rules to help improve business performance. In conversations with financial and marketing professionals, we have found that corporate leaders prefer to manage bundles actively in the sales cycles. Meanwhile, most companies are still focused on trying to move individual product sales forward using product-specific marketing techniques.
In every transaction, the revenue recognition rules establish a revenue profile. But few look to adjust the profile by merely introducing or removing components from the transaction bundle. Where the deferred revenue is substantial, companies can front-load revenue by adjusting the hardware/product sales to pull forward a larger proportion of the revenue into the current period. Alternately, product-heavy companies can offer service or equipment upgrades to push back revenue, as appropriate.
Relatively simple examples exist in the mobile phone market, where handsets and services can be bundled with hands-free devices or other accessories to pull revenue forward. On the other hand, bundling the same handset with insurance or a warranty can push the revenue back. In the more complex world of construction equipment, adding equipment repair services or future replacement parts lets companies charge customers more initially, but also allows these companies to move the revenue profile to future periods.
One interesting vignette on this concept again deals with Apple. During the recent introduction of the new iPhone, there was also a new release of the operating system that was for both the first generation iPhone and the iPod Touch. Apple made a conscious decision to charge current owners of the iTouch for operating system upgrades so that the original "product" sale was not coupled with a perpetual software upgrade service -- suggesting that a portion of the original product sales revenue should have been deferred.
Not only was the decision astute, so as not to create a revenue deferral scenario for the product itself, but also it probably brought Apple a sizeable amount of additional licensing revenue that might have been given away.
Supporting Strategic Decisions with "Fair Value"
While FV and VSOE have been much maligned, there is real value in the management techniques that these concepts instill, and they are worth a deeper look. Both of these techniques are used to calculate deferred revenue. However, they are just as applicable in the case of revenue apportionment and allocation for bundled sales, no matter the deferral periods or requirements.
In a multiproduct/service management organization, business leaders often have heated conversations on revenue sharing for customers. For example, when a cable company offers a "triple-play" package of voice, video, and Internet access, should the monthly service revenue be split evenly so that product profitability reporting can be performed? If not, what would be an equitable division? What would be the method to determine the relative value of the three in each market?
In a uniform revenue credit model, no division is encouraged to improve the customer bundle. A value-based revenue-sharing model actually provides incentive for an organization to improve the product bundle over time to draw more from the revenue pool.
Organizations that establish and monitor accurate FV of a product or service gain an entirely new perspective on the performance of their product lines. There is real incentive for the cable company to add as much to the service offering as possible to increase revenue share in the bundled scenario, just as it would charge a customer buying each individual service.
Why is this not done today? There are a variety of reasons.
Most common is the lack of real information and infrastructure for valuing the services properly. The bundled revenue service was a particular problem in the telecommunications industry when long-distance services were delivered over the same infrastructure as the home service. It is still an issue in the financial services industry, where product "value" is hard to define, charges are processed through a shared environment, and product management is unclear.
In a bundled product offering, such as a consumer bank checking and savings account with a debit/credit card, should the card provider within the bank be reimbursed for the marketing and management of the services? If a reimbursement model is appropriate, then what portion of the monthly fee should be provided?
We have seen companies use a variety of scenarios and structures, but leaders are looking for more competitive revenue models.
While we do not condone revenue management, we believe that organizations can deliver better results by actively evaluating their presales, contracting, and delivery processes. Revenue recognition rules have a subjectivity that can represent an opportunity as well as a threat to companies. While in their current state IFRS revenue recognition requirements are actually simpler than the complex rules and interpretations of U.S. GAAP, we believe that sound management processes and techniques should not change based upon the latest accounting guidance. Evolutions in accounting requirements will occur over time, and companies must have the infrastructure, management disciplines, and techniques to help deliver to the bottom line.
Evolving into deferred revenue management without a clear understanding of how it will affect the sales, operations, finance, and performance of a company is just as much a failed strategy as ignoring deferred revenue opportunities in the first place. Once revenue is deferred, it awaits the action of the company or the customer. By using its infrastructure, a company can encourage the right behavior to convert deferrals into realized revenue.
Furthermore, with today's sophisticated modeling tools, the finance team can actually help its organization balance revenue across products and services to provide the engine to fuel growth and investment in the right areas. Whether for internal management reporting or for inclusion in external financial publications, the proactive use of revenue management methods is an emerging and powerful discipline to deliver consistent revenue and exceed investor expectations.
For those who have unknowingly been ensnared in the deferred revenue challenge, after-the-fact revenue accounting seems more like a wreck. However, there are those out there who manage to recognize the opportunities that the rules present -- we all can aspire to this higher capability and forethought.
1. Kara Scannell and Joanne Slater, "SEC Moves to Pull Plug on U.S. Accounting Standards," August 28, 2008, http://online.wsj.com/article/SB121985665095476825.html?mod=hpp_us_whats....
2. Ben Charny, "Apple's iPhone Dials Up a New Deferred Cash Hoard," cellular-news, July 18, 2008, http://www.cellular-news.com/story/32503.php.
3. Lingo, Residential Calling Plans, retrieved August 26, 2008, from http://www.lingo.com/voip/residential/home_plans.jsp.
4. Apple 10Q Statement, June 28, 2008, page 20, http://library.corporate-ir.net/library/10/107/107357/items/301504/AAPL_....
See author Alok Ajmera explain how companies that view revenue recognition rules as just another example of plus-sized accounting complexity are overlooking a keen opportunity to boost investor confidence and grow value.