Bridging the Global Accounting Standards Gap

On Nov. 15, the Securities and Exchange Commission took a first step to drawing a road map toward use of globally accepted accounting standards by voting unanimously to allow foreign companies to file financial results using international financial reporting standards (IFRS) without reconciling the figures to U.S. generally accepted accounting principles (GAAP).

While SEC-sponsored roundtables question whether U.S. companies should stick with GAAP or move towards filing under IFRS, technology companies are already facing unintended consequences of the ruling.

Revenue Recognition

The framework under IFRS is principles-based compared to U.S. GAAP — which, particularly for revenue recognition, is a rules-based framework and more prescriptive in nature. When a company records revenue under U.S. GAAP, there is typically more specific and onerous guidance of how to record that revenue. Many of the U.S. GAAP rules were written to address perceived abusive practices, and to help achieve consistent application among companies.

The differences in revenue recognition accounting standards create situations where a foreign competitor is allowed to recognize revenue sooner for a particular transaction under IFRS where a US company would not be able to recognize revenue as quickly. In some cases, due to the differences between IFRS and U.S. GAAP, this timing difference could lead to a significant difference in valuation.

Technology Businesses Concerned

By its nature, the difference between the two accounting standards’ revenue recognition rules tends to impact technology companies more than other types of companies for two reasons:

1. Technology companies are more likely to have complex sales transactions that include multiple products and services, and this is one of the particular areas of U.S. GAAP that is more prescriptive and onerous.
2. The more principles-based nature of IFRS enables foreign companies to be more flexible when they recognize revenue, which is important for technology companies because investors view revenue recognition as the simplest way to understand a company’s worth. This could create a significant competitive disadvantage for U.S. companies, since international competitors might have more leeway in structuring sales transactions without adversely affecting the timing of recognition of the revenue, and might be perceived by potential customers and investors as being more successful due to earlier reporting of revenue.

A Few Examples

Technology companies often will sell more complex products that also require some level of ongoing customer support services. Under U.S. GAAP, this is considered a multiple deliverable sale containing both a product and ongoing service, and there are prescriptive rules that must be met in order to separately recognize the product sale at time of delivery to the customer. If these rules are not met, U.S. GAAP might require recognition of the product revenue to be deferred and reported as revenue on a pro rata basis over the term of the customer support services.

IFRS in this situation is not as prescriptive and, as a result, a company using IFRS would be more likely to be able to report the revenue from the product sale when the product is delivered to the customer, and would have more flexibility to negotiate favorable terms and pricing with the customer without jeopardizing the favorable accounting treatment.

Another example where IFRS is less onerous than U.S. GAAP involves transactions where a company gives a product to a customer at no initial charge if the customer enters into a service contract. A common example of this would be the free cell phones provided when a customer signs a one-year contract with a cellular provider.

Under U.S. GAAP, due to a specific rule, the company would be precluded from recognizing any revenue at the time the cell phone or other product is provided to the customer since the company must also provide the cellular or other services in order to recover the value of the free phone. However IFRS does not contain a similar rule, and as a result, a company using IFRS would generally be permitted to recognize the market value of the free phone as sales revenue when provided to the customer, even though payment will only be received for the future services to be provided.

In the above examples, a company reporting under IFRS has more flexibility to offer free or discounted products to attract customers without adversely affecting reported revenues than a company reporting under U.S. GAAP. As a result, in a competitive situation, the U.S. company might need to choose between providing the customer concession or special terms in order to be competitive and maintaining a favorable revenue model in order to meet investor expectations.

Looking to the Future

While an astute investor might be able to determine from financial statement disclosures that potential differences in the accounting exist as a result of a foreign company’s use of IFRS instead of GAAP, investors typically would not be able to quantify the effects of these differences, absent specific requirements that companies disclose this information. Under the new rule, this disclosure will no longer be required.

Another potential rule change being considered by the SEC is also garnering much attention: allowing U.S. companies to adopt IFRS in lieu of U.S. GAAP. The SEC is currently reviewing comment letters submitted in November and has already hosted roundtables to address the issue. This change, if it were to occur, has its own issues, including a lack of accountants in the U.S. that have expertise in IFRS.

To address the current issues facing U.S.-based technology companies, management should discuss differences between IFRS and U.S. GAAP with their accounting firms and stay abreast as much as possible regarding industry trends. This upfront homework could make the difference in maintaining an investor-friendly environment and closing a competitive sales deal.