New standards limit "smoothing" of revenue and income in long-term service contracts

By Sam Klaidman and Ron Giuntini

Introduction

For many years, revenue recognition financial accounting has not been one of the things that an Aftermarket Services Leader has worried about. But the situation is changing because on May 28, 2014, the United States Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606, regarding revenue from contracts with customers.  These changes are in effect now for public companies and in November 2018 for private ones.  The impact of ASC 606 is on enterprises selling multi-year contracts or includes such contracts as part of multi-year operating leases.

As a result of ASC 606, there will be a number of significant changes to processes and procedures that will affect Aftermarket Service Leaders and their organizations. The core principle is that revenue is only recognized when the delivery of a service matches the amount of consideration expected in exchange for that particular service, i.e. regardless if that service is part of a larger contract with term payments for a bundle of services.  In other words, we now only recognize revenue where there is a related offsetting expense in the same period. And here are the most significant impacts of ASC 606:

  • Bonus calculations, previously based on bookings, may change because the revenue recognition will not be as predictable as previously
  • Likewise, sales commissions may also change for the same reason
  • Automated systems will have to change to link the Service Management System to the Financial Accounting System used to recognize revenue
  • Because of the previous bullet, it will now be easy to determine the profitability of individual contracts as well as the efficiency of contract pricing based on contract type, product, geography, market, application, or however you segment your customer base
  • It will also be easy to link individual contract profitability to customer satisfaction and loyalty measures.

 

Background

Let us first acknowledge that this subject is “dry” and “in the weeds”, but NOT reviewing its applicability for your firm could result in some future major financial reporting adjustments; a major negative indicator for investors.

Revenue recognition is a financial accounting term that is all about a provider of a service aligning the events driving their costs with the payments they have received from their customer; a basic tenant of accrual accounting.  At the end of the contract all cumulative costs are recognized, as well as payments collected, and if revenues have been greater than costs, then an enterprise has engaged in a profitable contract, if not, they have incurred a loss.

Note that investors are paying much closer attention to recurring revenues; they are often highly prized by the investment community at providing predictable profits.

For example, if you were running a retail store, any revenue would immediately show up in your income statement, as well as the cost of the good.  But in a business where the customer is charged up front for an extended benefit period, you have to go through the revenue recognition process.  Examples of extended benefits include:

  • Paying in advance for an airplane ticket
  • Buying season tickets to the opera or Red Sox
  • Buying an extended warranty or service contract

Also, note that the term “revenue recognition” is not only applicable to Service Contracts; it can be employed for made-to-order production contracts, construction contracts, and others.

 

Understanding the traditional way to recognize service contract revenue

If you only sell a one-year service contract, then revenue recognition financial accounting is not required; all revenues and costs are reported in the same accounting year.

Your accounting department will typically have an Excel spreadsheet which lists each contract in the left-most columns and each month across the top row.  They may recognize the revenue by dividing the total contract value into 12 equal cells and at the end of each month move one-twelfth of the contract into the monthly revenue account.  That movement is called revenue recognition. The assumption of such calculations is that costs are in fact “exactly” aligned with revenues.

 

The background to the change in revenue recognition

Because Service revenue is becoming more important to businesses all the time, the Accounting community felt that the current method of recognizing revenue is susceptible to manipulation, and as a result, financial performance could be misleading for investors.

If you think about the Excel spreadsheet described above you can see that the revenue is recognized based on a pre-defined time interval and the expense is recognized as it occurs.  When service contract revenue was a relatively small part of total income the timing errors were not materially significant and no one cared if the service contract revenue fluctuated around the correct value.

Note that financial auditors considered long-term service contracts as immaterial for most firms.  For example, if an OEM generated $1 Billion/year of revenue and such a service contract constituted $10 million of revenue per year, or 1% of revenues, the accountants considered such revenue as “immaterial” and never performed a deep-dive into the actual alignment of payments and costs.

However, more recently, service contract revenue has become, for more and more enterprises, a larger percentage of their total income.  Also, investors are more focused on paying a premium for enterprises with recurring revenues.  So, taken together there is a perceived opportunity to manipulate, at least in the short-term, when revenue is recognized, to distort quarterly profits and impact stock prices.

Think about this:  What if a business knows that there will be a large order hitting the company in early April (the start of Q2, in many cases).  To smooth out the profit picture a business may shift recognition of some service contract revenue from Q2 into Q1.  This is very easy to do when you have the “black box” of unrecognized revenues.  So service in Q1 is “way up” and in Q2 will be “way down.”  And leadership is thus caught in a game of constantly landing new contracts and manipulating them in order to avoid a revenue drop; it can get pretty ugly.  Often steep discounts are provided to land the contracts resulting in actual losses at the end of the contract.  There have been some very large scandals as a result of this manipulation.

But what about the people who bought and/or sold stock in Q2 based on the inaccurate results reported in Q1; Often lawsuits will ensue.

 

The new way to recognize service contract revenue

 On May 28, 2014, the United States Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606, regarding revenue from contracts with customers.  These changes are in effect now for public companies and in November 2018 for private ones.

ASC 606 provides a uniform framework for revenue recognition from contracts.  The core principle of ASC 606 is that revenue is recognized when the delivery of promised goods or services matches the amount of consideration expected in exchange for the goods and services.  In other words, we now only recognize revenue where there is an offsetting expense in the same period.

There are six steps that allow the recognition of revenue under that core principle:

  1. Identify the contract. This not only means that a contract must actually exist but that you have a reasonable expectation of collecting the agreed amount of money.
  2. Identify the contractual performance obligations such as PM visit, repair of a specific part of the equipment under contract, provide and install a software upgrade, or provide remote troubleshooting support.
  3. Determine the amount of consideration/price for each transaction. For example, a PM visit may be worth $250 plus the expected actual travel and labor expenses associated with each contract.
  4. Allocate the determined amount of consideration/price to the contractual obligations. This means notifying the Accounting Department each time you either post expenses, labor, or no expense service so they can make the entry to recognize the appropriate revenue identified in number 3, above.
  5. Accounting can then recognize revenue when or as the performing party satisfies a performance obligation.
  6. Only when a multi-year contract expires can the Accounting Department then recognize any remaining revenue resulting from the Service group not doing one or more performance obligations. So, if you sold a service contract on a car and projected replacing a starter motor, at $500.00, and you never had to perform this service, then in the last month of the contract you can recognize the $500.00 with no associated expenses; a nice profit upside for your P&L.

 

What this means for the Service Executive

For the service organization, it means more back-office work and more issues with not meeting budget.  First, let’s discuss the back-office work.

  1. For each new multi-year contract and each unique product, you will have to identify each unique performance obligation and the month when you expect this to occur. Using our car service example, you must list out the expected service obligations, identifiable costs, variable costs, and expected time of service required.  Then you must add in the variable costs you expect to pay.  For example, if we projected replacing the starter motor your backup information would look like this:
    1. Material cost – $400 minus $200 core credit or $200
    2. Repair labor – 4 hours x $70/hour or $280
    3. Towing car to shop – $80 x 0.5 or $40 (Towing is needed about half the time)
    4. shop supplies – $10
    5. Profit – $70
    6. Total – $600
    7. When – Feb. 2019
  2. You must notify the Accounting Department every time your group performs a contract obligation. Accounting then has to recognize only the amount you projected in step #1.  You can see that this effort will be full of assumptions, guesses, and errors.
  3. Unplanned work will have to be managed very carefully. For example, if you projected two software upgrades per year and the company releases three then the third upgrade should either be charged to another account or to the contract with no offsetting revenue.  At the end of the contract it will all wash out but along the way, there will be many unexpected events.

The reasons there will be many discussions about meeting or missing budget are:

  1. Timing issues. You project the starter motor repair in Feb. 2019 and it actually occurs in Feb. 2020. In 2019, there was no revenue for the repair and your sales missed budget.
  2. As a good Service Executive, you collect data, analyze failures, and work with R&D and Manufacturing to make your products more reliable. Every time you avoid a failure on a contracted unit, you postpone recognizing the revenue until the end of the contract, which could be after you retire or move on.
  3. As your contract expenses come in below budget, overall a very good thing for the company, you may start receiving questions from the contract or product sellers like “why can’t we reduce our contract price?” Makes sense until the CFO hears that you are thinking about making such a proposal and then she will be all over you because you are leaving money on the table.
  4. And on and on…

Note that one way to avoid all the above details is to consider a portfolio of a variety of contracts and recognize the average costs to be incurred per period with the average revenue to be generated per the same period. On the macro-level this approach may provide you with “a lot less work” but you will have lost the granularity required to analyze profitability or loss of each contract during its life.

 

In conclusion

Do not try doing anything about this until you and the CFO have an open discussion about how you plan to move forward, what assistance can be provided (probably including using your external auditor as a Consultant) and what schedule you want to meet to reset open contracts as well as the financial accounting reporting of all future contracts.

This is a big effort for most companies and requires close cooperation among all the affected groups.

Best of success.

 

Sam Klaidman is a Si2 Expert in Service Marketing, Service Operations Management, Customer Value Creation and Customer Experience. He helps clients achieve their growth objectives by designing and commercializing new services and the associated business transformations. He is Principal at Middlesex Consulting and is based in Massachusetts.

Ron Giuntini is a Si2 Expert in Service Logistics, Performance-Based Contracting, Product Support Business Case Analysis, Life Cycle Financial Analytics and Configure-Price-Quote (CPQ) processes of vendors of performance-based contracts and services, in particular for industrial and military maintenance management. He is Principal at Giuntini & Company Inc and Founder at G35 Software, Inc. He is based in Pennsylvania.

 

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