On October 30, 2018, Reuters published an article titled “General Electric reveals deeper regulatory probe, restructuring.” In the section titled INVESTIGATION DEEPENS, the article reported:
GE has said it learned of regulatory scrutiny last November, when the SEC said it was investigating GE’s accounting for long-term service agreement revenue.
While an investigation does not mean proven guilt, accounting for long-term service contracts has been the subject of the 2014 new US and International Accounting Standards issuance.
Specifically, 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 became effective for public companies and private ones in November 2018. The impact of ASC 606 is on enterprises selling multi-year contracts or including such contracts as part of multi-year operating leases.
On October 8, 2018, Ron Giuntini and I published an article about these new accounting rules. In this article, we explain the” old” way long-term service agreement revenue is recognized:
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.
This method works when the total annual revenues recognized from contracts-in-force are not “material” to the business’s financial results; this means that contract revenue is significantly less than 5% of total revenue. Of course, this method fails to attempt to match revenue and expenses in the same time periods, but again, it is not material to the shareholder’s decision-making.
Note that “materiality” does NOT consider profitability; it only refers to revenues. As a result, there is an assumption that contracts have the same profit margins as the sale of a product, which is false; contract profit margins can be anywhere from 50% to 200% higher than that of products. So, is employing the financial accountant’s “materiality” assumption of often “ignoring” contract oversight the right path to take?
But what happens if the contract revenue is deemed material by leadership? One possible outcome is that someone in the enterprise can “play games.” For example, individuals can recognize contract revenues before or after a performance event, the driver of revenue recognition, to craft a more favorable overall revenue picture. Such “games” may not change overall revenue recognition throughout the contract’s life, but they can materially impact short-term KPIs.
As we wrote in our article:
ASC 606 provides a uniform framework for revenue recognition from multi-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.
Let us look at three examples of the materiality of long-term service agreement revenue to GE business segments as reported in their 2017 Annual Report. (All numbers in US$ Billion):
Service revenue (frequently Long-term Service Agreement Revenue) is material in the example’s three business segments.
The outcome will be exciting when the SEC completes its investigation and reports its findings. Until then, I don’t believe there is anything further to say. Good luck, GE.
Update: After this article was posted, a PhD Accounting Professor friend of Ron Giuntini told him that break/fix events in a contract can be treated like insurance; you can straight-line their revenue recognition.
Planned maintenance activities are event-based and must be treated as described in this article. However, if the contract is nearing its end, you don’t have to recognize the revenue until then and make adjustments in that financial period.
The key is that whatever approach you take, it is presented to the auditors, who want an audit trail of how you recognized revenues during the life of the contract.
Also, it appears that 2-3 year contracts have much less rigorous revenue recognition reporting than 4+ year contracts.
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