“Investors Worry Revenue Rules Will Allow Earnings Manipulation” announces a recent article on the Bloomberg BNA website.

Here are some extracts from the article, written by Steve Burkholder:

• Some investors worry that revenue accounting rules that public companies must begin using in January will yield inconsistent reporting and allow earnings manipulation, according to Bloomberg BNA interviews with investors and their advocates.
• The new U.S. and international accounting rules on revenue—deemed the most important single line in the financial statements—call for significant judgments by companies.
• “The fear is that companies will take advantage of that,” David Zion, of Zion Research, New York, said May 26 of the leeway in the new rules. “The fear is the aggressive representation.”
• …The accounting rules “could cause revenue to be recognized earlier or later, lumpier or smoother,” according to Zion, who formerly worked at Credit Suisse First Boston and Bear Stearns. “It will impact all companies (to varying degrees).”
• “The key question is will it change behaviors,” Zion wrote in a recent report on the revenue standard. “For example, will management try to adjust their contracts with customers to get a better revenue recognition pattern or launch new products because the revenue recognition will make more sense?”
• Zion also warned of inappropriate financial reporting behavior in his firm’s preview of the shift to the sweeping revenue standards.
• The rules will bring more management judgment to top-line revenue numbers, including on estimates of revenue and on when to book revenue on long-term customer contracts that are subject to change and variable payments.
• “In theory that should mean revenue will better reflect the underlying economics,” according to the Zion Research Group’s report. “In reality, it may result in some monkey business.”

A couple of the article’s interviewees express the view that “investors will rely more on measures of cash and cash flows,” with one saying that actual cash from revenue “is still what matters.” The article closes by citing former SEC Chief Accountant Lynn Turner: ““This new revenue standard increases the use of judgments and in doing so, increases the possibility that financial statements will be manipulated to the detriment of investors.”

The article seems to me rather depressing in that it doesn’t seem to set out any specific reason for fearing that these judgments associated with these standards will be applied with a particular lack of integrity. Rather, it’s simply built on a basic assertion that – as Turner summarizes there – judgment inherently equals an increased possibility of manipulation. Of course, in itself, that’s merely stating the obvious – plainly, an amount that requires some degree of human assessment and reflection is subject to greater potential fallibility than one which (say) is simply copied off a bank statement. But that affects every single aspect of IFRS in one way or another, so it’s really not saying anything at all.

For a relatively straightforward business where the cash comes in the door more or less as goods or services go out, it’s no doubt fairly safe (in this limited respect anyway) to focus on cash flow measures above all else. Such an approach seems more questionable though when applied to more complex business arrangements where (for instance) a large part of the cash might come in before the related goods or services are transferred to the customer (as in the perpetually popular instance of the non-refundable upfront fee). Of course, you might choose to take the view that such matters will tend to wash out over time, so that focusing on the cash is still an acceptable simplifying approach. But then, any “monkey business” applied by management to the judgments required by IFRS 15 will also have to wash out over time (unless management can find a way of hiding the price of its sins within some other financial statement item, which presumably wouldn’t work forever). So it’s hard to see for such companies why a stubbornly cash-centric view would necessarily be so superior.

It’s also hard to see why someone would want to invest in a company anyway, unless he or she had a basic level of confidence in management’s integrity. After all, judgments about applying IFRS 15 are just one small category of all the judgments (strategic, ethical, financial, political etc. etc.) that an entity has to make, so it seems odd to assume that a company’s transgressions would be confined to the accounting, without affecting the underlying substance. Looked at that way, if you’re suspicious about whether a particular entity is applying IFRS 15 appropriately, such suspicion might actually provide a useful warning bell about possible deeper problems. The interviewees in the article don’t sound too confident about the quality and usefulness of the expanded disclosures to be made under the new standard, but again, poor-quality disclosure will presumably send its own message about an entity, providing a basis for greater skepticism.

None of this means investors should ignore the concerns expressed in the article. But in itself, carrying around a generalized worry about “earnings manipulation” is about as useful as getting up every day and worrying about “nuclear war.” Sure, spend your life in a bunker if you want, and don’t invest in any companies where management judgment might even conceivably lead you astray. You might live longer that way; as the old joke puts it, it’ll feel much longer anyway…

The opinions expressed are solely those of the author