Revenue Recognition For The Aftermarket Services Leader

by | Oct 8, 2018 | Growth

Long-term Service Agreement Revenue

New standards limit the “smoothing” of revenue and income in long-term service contracts

By Sam Klaidman and Ron Giuntini.  This post originally appeared on Si2 Service in Industry Hub

INTRODUCTION

For many years, revenue recognition financial accounting has not been one of the things that an Aftermarket Services Leader has worried ab ut. 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. The impact of ASC 606 is on enterprises selling multi-year contracts or includes such contracts as part of multi-year operating leases. These changes are in effect now for public companies and in November 2018 for private ones.

As a result of ASC 606, several significant changes to processes and procedures will affect Aftermarket Service Leaders and their organizations. The core principle is that revenue is only recognized when service delivery matches the amount of consideration expected in exchange for that service, i.e., regardless if that service is part of a more significant contract with term payments for a bundle of services s. In other words, we now only recognize revenue with 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 once.
  • Likewise, sales commissions may also change for the same reason
  • Automated systems will have to adjust 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 significant financial reporting adjustments, a primary negative indicator for investors.

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

Investors pay much closer attention to recurring revenues, often highly prized by the investment community for providing predictable profits.

For example, if you were running a retail store, any revenue would immediately show up in your income statement and the cost of the good. But you must go through the revenue recognition process in a business where the customer is charged upfront for an extended benefit per d. Examples of comprehensive 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 that lists each contract in the leftmost columns and each month across the top row. Such calculations assume that costs are “exactly” aligned with revenues. 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 BACKGROUND TO THE CHANGE IN REVENUE RECOGNITION

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

Considering 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. No one cared if the revenue fluctuated around the correct value.

Note that financial auditors consider long-term service contracts as immaterial for most firms. For example, if an OEM generated $1 Billion per year of revenue and such a service contract constituted $10 million of revenue per year, or 1% of revenues, the accountants considered such income “immaterial.” They 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 more significant 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.

Consider this:  What if a business knows that a large order will hit 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 1. This is very easy to do when you have the “black box” of unrecognized gain. So service in Q1 is “way up,” and Q2 will be “way down.” And leadership is thus caught in a game of constantly landing new contracts and manipulating them to avoid a revenue drop; it can get pretty messy. 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 s. In other words, we now only recognize revenue where there is an offsetting expense in the same period.

Six steps allow the recognition of revenue under that core principle:

  1. Identify the contract. This means that a contract must exist and that you reasonably expect to collect the agreed amount.
  2. Identify the contractual performance obligations such as PM visit, repair of a specific part of the equipment under contract, providing and installing a software upgrade, or providing remote troubleshooting support.
  3. Determine the amount of consideration/price for each transaction. For example, a PM visit may be worth $250 plus each contract’s expected travel and labor expenses.
  4. Allocate the determined amount of consideration/price to the contractual obligations. This means notifying the Accounting Department each time you post expenses, labor, or no expense service so they can enter 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 recognize any remaining revenue 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 SERVICES EXECUTIVE

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

  1. For each new multi-year contract and each unique product, you must identify each unique performance obligation and the month when you expect this to occur. Using our car service example, you must list 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 incur. 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 whenever your group performs a contract obligation. Accounting must 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, suppose you project two software upgrades yearly, and the company releases three. In that case, the third upgrade should either be charged to another account or the contract with no offsetting revenue. At the end of the contract, it will all wash out, but there will be many unexpected events.

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

  1. Timing issues. You project the starter motor repair in Feb. 2019, which occurred on Feb. 2, 2020. In 2019, there was no revenue for the repair, and your sales missed the 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?” It 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 various contracts and recognize the average costs incurred per period with the average revenue 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 the 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.

About Middlesex Consulting

Middlesex Consulting is an experienced team of professionals with the primary goal of helping capital equipment companies create more value for their clients and stakeholders. Middlesex Consulting continues to provide superior solutions to meet the needs of its clients by focusing on our strengths in Services, Manufacturing,  Customer Experience, and Engineer g. If you want to learn more about how we can help your organization deal with new revenue recognition rules, please contact us or check out some of our free articles and white papers here.

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 the Founder of G35 Software, Inc. He is based in New Hampshire.