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Putting the E in “revenue”: A big challenge of the new rev rec standard

Accounting professionals who have been involved with revenue for many years can recite the four criteria for revenue recognition as quickly as they can their children’s names—it just becomes second nature. For people less familiar with the process, I have used a mnemonic—it’s like learning your ABC’s but without the AB—you can sort the criteria into Collection, Delivery, Evidence, and Fixed Price (C, D, E, F). Gimmicky, but it works.

Well, we’re all going to need new hints for taking on the new revenue recognition standard when it goes into effect. The adoption date may be a ways off with FASB’s recently announced one-year delay, but finance teams still need to get their heads around the changes. Implementation challenges are ahead, and contingent revenue related to bonuses and penalties will be particularly challenging for some organizations.

The new big “E”: Estimates
While many of the same concepts will still exist, the framework of the standard moves to a five-step process rather than relying on criteria. So while collectability, delivery, evidence of the arrangement, and even some aspects of fixed or determinable pricing still come into play, that last aspect is where I see the biggest challenges.

If I had to create a new term for what we currently view as the “fixed or determinable” part of rev rec, I would call it “fixed or estimable” for the new standard. It requires, in almost all circumstances, entities to estimate the amount of contract consideration that they believe they are entitled to (assuming that recording such revenue would not likely result in a significant reversal of revenue in the future). So, there will be more judgment involved and this will require a change in practice.

Much has been written about how the new standard will require organizations to not only make many more estimates but have systems to support those estimates, provide more disclosures in their filings, and have controls to ensure that the system that supports the estimates is controlled—this isn’t about someone just throwing a dart at a board! This is why now is the time—while we all have it—to take a close look at your systems and processes and decide whether they’ll need to be modified to make room for the flexibility that’s needed when you’re dealing with estimates.

You say tomatO, I say tomAto: A bonus and penalty can be the same thing!
How is this different than current practice? Consider this pretty straightforward example of how a contract with a bonus (or penalty) provision would be treated today versus the new standard. Keep in mind this deal (from an economic perspective) can be structured using either a bonus or a penalty.

Assume Customer A purchased a single hardware element that qualified for separate accounting (i.e., it is not a multi-element arrangement). The vendor structures the deal at a fixed price of $10K for Customer A with the understanding if the product meets certain performance parameters after 60 days (i.e., uptime), the vendor gets a bonus of $2K. Then consider a deal that same vendor makes for Customer B: It charges the organization $12K with the understanding it would have to give back $2K if those same parameters are not met.

Current U.S. GAAP treats both these contracts the same—it is a classic “substance over form” example and the reality is that both customers negotiated the same deal. But there’s that $2K unknown; since it does not meet the fixed or determinable criterion, the vendor cannot count the $2K contingent amount as revenue until that 60-day contingency passes (at which point both the vendor and the customer will know if the uptime spec was met). It’s the same scenario even if the vendor can show that 100% of the time it has achieved the specs it’s promising.

Now, fast-forward to the new standard—this contingent revenue will have to be estimated and recorded up-front. The result is binary—either the vendor records the $2K payment or not. This time, if the vendor has a strong history of meeting its performance specs, it would book the $2K. Or it could estimate a weighted-average probability amount if the amount it expects to receive falls within a range of possible outcomes. This would be more appropriate if the contract bonus depended on a percentage of spec achieved (i.e., a different example).

The bottom line
In almost all companies, a purchase order is a big factor for determining the ceiling for revenue recognition. Using our super-simple example above (if only all rev rec determinations were that easy!), the vendor may receive a PO of $10K from Customer A but $12K from Customer B. But let’s say Customer A ends up following up with a second PO for $2K when the performance bonus was earned—just as the vendor predicted. Under the new rule, the vendor would have already recorded $12K for that contract even though the PO said something else—this discrepancy could create challenges for many companies from a systems perspective.

Also important to understand is that the first step of the new standard—determining the contract—contains the old collectability criterion in it. Put another way, you can’t have a contract if you don’t have a contractual right to payment with a credit-worthy customer. In our example, the contract value is “potentially” $12K regardless of the amount and timing of POs received.

Ultimately, companies need to have a process in place and should look at how their ERP system may handle situations like this. Manual, off-line, Excel-based tracking may seem like a reasonable solution, but in my experience, it introduces too many risks for errors and inefficiencies.

In addition to the accounting considerations, the new standard could let sales organizations give customers more contracting options. Often, the finance or accounting organization has had to “hold back” certain deal structures to ensure revenue rules were met. Given the focus on the big “E”—estimates—in the new standard, many organizations will find that they can create contracts with more value for their customers and alter contractual language, win more business and, in turn, increase profits—although that is just my estimate!

Looking for more insight on the new revenue recognition standard? RoseRyan and FinancialForce.com teamed up for a new report that gives companies a starting point for planning for the changes, explaining who should be involved, what areas of the company should be impacted and how to move forward. Click here to download the report: Quick guide to revenue recognition.

John Cook is a member of the RoseRyan dream team. He is a CPA with over 25 years of experience working in finance and accounting organizations in Silicon Valley with a focus on operational finance and technical accounting.

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The new rev rec rules: Making estimates that minimize the likelihood of restatements

Get ready for scrutiny. One of the many challenges presented by the new revenue recognition rules is the need for companies to come up with an estimate of revenue for variable consideration instead of waiting until amounts are certain as they do under current GAAP. Determination of these estimates involves significant judgment.

If public companies recognize an estimated amount of revenue that subsequently turns out to be unjustifiably overstated, they won’t be dealing just with the problem of non-GAAP compliance. They will also face a decrease in credibility among financial analysts, possible restatement of their financials and the threat of shareholder lawsuits alleging fraud. To avoid such troubles, companies need to make their estimates as bullet-proof as possible and establish sound practices for documenting their basis for those estimates.

How to pull that off? Even though the new rules don’t go into effect until 2017, companies need to begin rethinking their revenue recognition process now to minimize their risk of off-track estimates. Yes, there’s a fair amount of work involved up-front, but there’s a payoff (hang on, we’ll explain).

The new five step process
The new rules direct companies to apply a five step process for analyzing contracts with customers and deciding when and how they should recognize revenue. Step 3 is “Determine transaction price,” which requires, for variable consideration, companies to estimate a transaction price as either the expected value of possible outcomes (a probability-weighted estimate) or as the “most likely amount” (from a range of possible outcomes). Here’s where the challenge comes in: However a company proceeds, the rules specify that the estimate must be an amount for which it is “probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty … is subsequently resolved.”

As an example, consider the difficulty of achieving that goal in a distributor model. Many technology businesses use distributors to sell and support their products across a broad customer base. To avoid overpaying for tech products amid short life cycles and constantly decreasing prices, distributors usually insist on having price protection in their agreements. That way, they can claim a price protection rebate from the manufacturer if they have to resell a product at a price below the initial, agreed-upon margin.

Under current GAAP, a company waits to recognize revenue until the price is “fixed and determinable.” A manufacturer recognizes revenue only when its distributor has sold the product to an end customer and requested its price protection, if needed, because that’s when the price is fixed and determinable. However, under the new rules, the manufacturer will often have to record a minimum amount of revenue at the time of shipment to the distributor, meaning it will have to estimate the impact of price protection it will have to grant.

Another example is found in licensing arrangements. Many such agreements include milestone payments that are contingent either upon performance of the licensor (a performance obligation under the new rules) or upon performance of the customer, such as when a drug-development customer achieves success in a critical trial (variable consideration that the licensor might receive after performance of its obligation for delivering the license but is only receivable if the customer achieves its goal). Under current GAAP, a company excludes contingent payments from the revenue allocated under a multiple-element arrangement and recognizes such contingent payments when the contingency is resolved. But with the new rules, when a milestone is considered probable, such payments become part of the transaction price and are allocated to performance obligations. This estimation and inclusion of contingent payments when they are considered probable — and not waiting until milestones are actually achieved — could result in earlier recognition of revenue if performance obligations have already been satisfied.

How to make good estimates
We’ve told you the “why,” now here’s the “how.” The following are principles for making estimates that will be defensible and limit the risk of a restatement.

Make estimating a team sport: Although it must lead the effort, finance should harness the expertise of other relevant functions within the company to make the best estimate. This means turning to sales and marketing personnel for their knowledge of customers, pricing and timing of sales milestones. The engineering team should weigh in on the readiness of a new product or confirm whether technical problems are causing returns or rework. The operations team will need to provide input on the probability of achieving performance milestones. Some companies will need to supplement this team of internal advisors with customer staff who are in direct touch with end customers (for example, this could be distributor personnel who manage the channel).

Use the best tools for the best results: Any company affected by the new rules will need robust systems to obtain up-to-the-minute volume and pricing information to prepare its estimates for financial close.

In the distributor example, large global distributors already have excellent systems that provide bookings, billings and backlog by customer and by part, in real time. Companies using smaller and regional distributors with less sophisticated systems may need to work with them to enhance information flow to the level they need. Online software tools from third parties that are specifically built to manage the manufacturer-distributor relationship can be very helpful as well.

In other industries, tools may not be in place to make estimates at all, or they may be focused on a specific step such as allocation of revenue to multiple elements in a software licensing arrangement at the start of the contract. For these circumstances, companies will need to develop tools to monitor contingent elements and determine their probability each reporting period.

Document and disclose: Companies should systematically document how they came up with each estimate — the process used, the historical information input, the personnel involved by function, the assumptions made and the risks mitigated. They should apply a consistent approach over time. If circumstances require a change in approach, then document the change and why it was required. All this information should be archived in such a way that it can be brought out any time to compare to actual figures and explain and justify differences to auditors, financial analysts and potentially the Securities and Exchange Commission.

The new rules require companies to disclose in notes to financial statements “sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue,” along with existing requirements to provide disclosures about significant accounting policies and critical accounting estimates. Given the increase in estimates and judgments, companies should use these disclosures to provide information on the assumptions and risks inherent in their estimates. Taken together, the documentation and disclosures should reflect how the company made a competent good-faith effort to develop its estimate.

Watch what’s on the horizon: As part of their estimation process, companies need to identify current factors that differ from prior periods that may drive estimates away from prior trend lines. Broader economic and industry trends can overwhelm their prior revenue trajectory. The financial crisis of 2008 and the tech downturn of 2000 are examples of extreme events that had a tremendous impact on the revenue estimates of companies that had nothing to do with the downturns themselves. A rising tide can lift all boats, and a swift ebb tide can strand them all on the sand.

Technology companies need to focus in particular on the impact of newly introduced and end-of-life products. A strong new product ramp can drive volumes above the trend line and improve pricing. But it can also accelerate the decline of an older product. For both large external events and tech product changes, companies should be especially careful to state their assumptions about the events and the impact on their estimates, both in their documentation and financial statement disclosures.

The plus side of this additional work
Making good estimates to meet the new rev rec rules will require companies to apply more time and thought to their revenue recognition efforts. But there’s good news in here as well: Finance teams can use this challenge as an opportunity to better understand their business, customers and products, and communicate that understanding to investors. That’s the type of scrutiny we can all root for.

Ray Solari is a member of the RoseRyan dream team. He has served as the CFO/VP finance for private companies and managed SEC reporting for public companies. He began his career at Deloitte.

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Does the FASB need to step back and simplify?

Having been involved in accounting for over 30 years, I have seen quite a few changes in accounting requirements, all enthusiastically introduced to “help the reader understand the financial status of a company better.”

I have to say that I believe the opposite is happening. Reading (interpreting) accounts is getting harder to do, as more and more intricate rules are introduced. In just the last 20 years, we have seen significant changes, including the introduction of stock compensation standards, revised fair value accounting, rewrites of revenue recognition rules, to name just a few. The changes have become intricate and mind-numbing.

There’s little sign of it stopping; although recently the FASB announced it will be focusing on reducing complexity and promoting simplification in its accounting standards, the Board has taken no meaningful action to date to do so. Board members have stated they want to simplify how inventory is measured and eliminate the need to disclose extraordinary items from income statements, but these pale into insignificance when compared to the revamped revenue recognition rules and the new operating lease accounting rules likely to be introduced too.

The bottom line is that unless you have a sophisticated understanding of accounting, you probably are unable to fully understand the accounts and what they mean to the health of the business. I don’t believe I am the only one who thinks the rules are going too far, and I understand sophisticated accounts! Every time I listen to a public company announce its quarterly financial results, I hear the CEO or CFO announce their earnings, and then they follow it with a pro-forma result, usually described as an “adjusted EBITDA,” which is to them a more meaningful result to disclose to their investors. Absolutely every company will back out stock compensation costs and other non-cash charges to get to a baseline cash-based result. Observers who trend these revised numbers on a quarterly basis can probably get a more meaningful trend of financial performance of the company and can make more meaningful decisions affecting their investment than if they tried to follow along with the pure GAAP figure.

I’m not saying cash-based accounting is the way to go. That is accounting at its simplest but that, too, doesn’t give a true picture of a company’s financial health. The reality is a simplified disclosure process is in desperate need. Maybe if this was introduced, companies would stop releasing pro-forma results, and I wouldn’t keep being asked to interpret accounting results into meaningful information. Seeing the proposed new rules on the horizon, it looks like it’s going to get worse before it gets better, which is unfortunate.

Until we see more progress, I expect to hear more and more complaints that financial statements are becoming more difficult to interpret. That to me is doing the U.S. accounting profession a major disservice.

Stephen Ambler is a director at RoseRyan, where he manages the development of the firm’s “dream team” of consultants. His interim CFO stints at RoseRyan have included a social media company and the management of the financial integration process at a company acquired by Oracle. He previously held the CFO position for 13 years at Nasdaq-listed companies. 

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Non-GAAP measures: Do they provide helpful insights or hide the “bad stuff”?

Many companies, especially in tech, supplement their income statement produced under generally accepted accounting principles with a non-GAAP income statement. It’s a practice that has proliferated in recent years as companies want to focus attention on the underlying “run rate” of the business and feel pressured to copy what their competitors are doing. Critics label non-GAAP measures as companies presenting “income before the bad stuff.” It’s true that presenting financials on a non-GAAP basis often has a major impact on the bottom line presented, by doubling a profit margin or turning a loss into a profit (as shown in our chart below).

Does non-GAAP reporting mean a company is hiding poor performance? Or is it providing investors with more information for judging the health of the business?

On balance, more disclosure is usually better. When companies present non-GAAP income statements in a thoughtful way and in good faith, investors will usually prefer the additional information and use the non-GAAP income to calculate P/E valuations. Note that most investment analysts report and focus on non-GAAP results. And the Securities and Exchange Commission has accepted their use as well, as long as the information is not misleading. The regulator outlines how and when companies can share non-GAAP figures with Regulation G.

So non-GAAP income statements look like they are here to stay. Let’s look at the most common areas where companies adjust GAAP numbers to give non-GAAP measures and why such measures have become accepted by both companies and investors.

Stock compensation: These are charges based on employee stock options and purchases that rely on theoretical models of their worth. Probably the most commonly listed adjustment to GAAP numbers, this charge is a lightning rod for criticism that GAAP has become overly conceptual and less relevant. As my colleague Stephen Ambler points out in his blog post “Stock compensation rules mask true operating performance,” stock comp charges are non-cash and can vary significantly depending on stock price and model assumptions, making it near impossible to compare two similar companies. Also, if the stock price declines, the company must continue recording the charges, which were based on the grant date value, even though the options have no value to the employees or to the company from a retention point of view.

Amortization of acquired intangibles: GAAP accounting for acquisitions requires the acquiring company to value the intangible assets of the acquired entity, other than goodwill, at fair value and amortize them over their useful lives. On one hand, the acquiring company paid hard cash or used its valuable stock to acquire these assets, and just as companies depreciate the purchase price of equipment they use in production under GAAP, they also should amortize their acquired intangible assets. They are matching cost with use over time. On the other hand, the amortization is a non-cash charge that the acquired business wouldn’t have shown on its own. To assess the sum of the underlying businesses, it is useful to show amortization removed.

Restructuring: These charges include such items as severance, facility and equipment write-offs, and contract termination costs tied to the resizing or closing of some part of a business. CFOs would prefer to keep the costs of these non-recurring events separate from the ongoing business’s results. Companies do need to be careful, though, that these “non-recurring” charges don’t recur every year or two! To mitigate abuse, Reg G sets rules for what is non-recurring — basically, it is something that hasn’t happened two years before the reporting date and is unlikely to happen in the next two years.

We commonly see the non-GAAP income statement remove other measures as well, such as the amounts paid to plaintiffs and attorneys to settle legal disputes or impairments of intangible assets or goodwill. Again, the rationale is to derive an income number that represents the fundamental ongoing business apart from non-cash charges and one-time events. The value to the investor is that these items are shown separately. The investor can value the company on its ongoing business while noting the size and frequency of these non-cash and non-operating charges.

To GAAP or to non-GAAP?
While investors are open and usually welcoming to non-GAAP income statements, they also value consistency. Companies should not use “good news” non-GAAP items and ignore “bad news.” Consider a company that accrues $1 million for a legal settlement and excludes the charge as a non-GAAP measure. It has effectively created a good news item. But if the actual settlement in a subsequent period turns out to be only $800,000, the company should include the $200,000 difference as a non-GAAP item when it comes time to report it. This difference may be perceived as bad news, but this keeps reporting consistent.

In general, companies should use an approach that relies on both full disclosure and moderation. Reg. G requires full disclosure, of course, including a presentation of the most directly comparable GAAP measure with equal or greater prominence as the non-GAAP measure, as well as reconciliation between the two. As for moderation, the investment community will reward companies that practice it, as moderate, thoughtful use of a non-GAAP income statement will build credibility and respect for the company. Finance pros who do these types of evaluations all the time can help you determine when applying non-GAAP makes sense for a particular situation.

Ray Solari is a member of the RoseRyan dream team. He has served as the CFO/VP finance for private companies and managed SEC reporting for public companies. He began his career at Deloitte. 

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A single set of global accounting standards seems like a dream, but there’s a sliver of hope

During my time in public accounting in Canada and throughout my experience in the U.K., differences between various countries’ generally accepted accounting principles were often front and center. There were continual discussions of a shared GAAP around the world—a utopian world for accountants, auditors and investors alike.

Initially, given the seemingly insurmountable challenges of converging disparate approaches, I was among the skeptics who thought reconciling differences between GAAPs would take a lifetime. I knew international standards were in the works and had spent enough time reconciling Canadian to U.S. GAAP for SEC filings to see the complexities of converging standards. Over the years, my outlook for converged GAAP has grown more optimistic. The challenges (politics, prioritization, variances in application and enforceability, cost and so on) continue, but the need for an international approach is greater than ever. Canada adopted International Financial Reporting Standards (IFRS) for most public companies for financial years beginning Jan. 1, 2011, and companies whose securities are publicly traded in the U.S. have the option of using U.S. GAAP. Canada does not get the benefit of a single accounting system until U.S. GAAP and international GAAP converge.

Fast-forward to 2013, and it is a time for celebration. The FASB has voted to move forward with the long-awaited final revenue recognition standard. (For details, read Diana Gilbert’s How the New Revenue Recognition Rules Should Help Global Businesses.) Joint FASB-IASB standards are expected in the areas of financial instruments and leasing.

IFRS has been adopted by 14 of the G20 countries for all or most companies in their public capital markets. The U.S. permits, but does not require, IFRS for foreign issuers. Investors and other stakeholders still need to know if U.S. GAAP or IFRS has been adopted, depending on the capital market. This makes things very complex: investors need to reconcile adjustments and disclosures for investments and subsidiaries, but also account for local variations in interpretations, applications, enforceability and audits. When implementation of aligned revenue standards is complete, that will be real progress, as investors will have confidence that they are comparing apples with apples on the top line.

Will this progress continue? How long will it take? The revenue standard was 11 years in the making, and priorities constantly shift. However, there is a new model for collaboration going forward. In April 2013, the creation of the Accounting Standards Advisory Forum (ASAF) was announced. This group of national accounting standards boards (including FASB) and regional bodies with an interest in financial reporting will provide both technical advice and feedback to the IASB. The ASAF had its fourth meeting Dec. 5 and 6. The agenda items included the 2013 Lease Exposure Draft (IASB) and the 2013 FASB Accounting Standards Update. ASAF received over 600 comment letters, and there are some significant differences in opinion. Leases will need to be re-deliberated, and there is skepticism about the chances for agreement on a converged approach.

Still, I am hopeful that the new ASAF will be successful in improving alignment. FASB Chairman Russell G. Golden has outlined a vision for more common and comparable financial standards, which he describes as a “new, decentralized, multi-lateral model of international standard setting that is consistent with the goal of promoting greater convergence in global financial accounting standards.” It is going to take time to find the right model, and hopefully the next 10 years will be more successful than the past 10.

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How the new revenue recognition rules should help global businesses

One of the issues global companies have always faced is how to manage a global sales force in an environment where local accounting rules for revenue recognition vary. Countless times, sales teams have vented to me because U.S. GAAP doesn’t allow us to recognize revenue when IFRS does. My response has always been that accounting rules should inform us, but they don’t define good business. Ultimately, the sales team needs to negotiate the best deal for the company (only one consideration of which might be whether or not we can recognize revenue), and we accountants will advise them on the best way to structure the deal and, ultimately, figure out how to account for it.

The new revenue recognition rules, expected to be issued simultaneously by the FASB and IASB in Q1 2014, will create a new global environment with enhanced comparability across industries and geographies. Global companies will be operating on the same playing field, which should give them some relief. OK, sales guys—time to stop venting and focus on making good business deals.

Judgment is a double-edged sword
The beauty of the proposed new rules is that they allow for judgment. However, that’s a double-edged sword, since filers have abused “judgment” in revenue recognition in the past and caused regulators (the SEC, EITF, AICPA, et al.) to respond by drawing “bright lines” in their issuance of “clarifying literature” (staff accounting bulletins, technical practice aids, EITF interpretations) to provide consistency in accounting and reporting where the FASB hadn’t drawn those lines. It will certainly be interesting to see how well regulators embrace this principles-based approach to accounting for revenue with this complete converged rewrite of international accounting standards.

Under the new revenue recognition rules, the five basic steps for accounting are:

  1. Identifying the contract with the customer. (Yes, sales team, you still need to include all of the deal in the contract. We still don’t like verbal side arrangements.)
  2. Identification of the separate performance obligations in the arrangement. (Similar to current multiple-element arrangement rules, these don’t need to have a price spelled out in the contract.)
  3. Determining the transaction price.
  4. Allocating the transaction price to the separate performance obligations in the contract. (This will require significant judgment, thus the need to thoroughly document the basis for your assumptions.)
  5. Recognition of revenue when each separate performance obligation is delivered.

The latest clarifications from redeliberations have added back a requirement for collectibility to be probable—and note that this is the one minor nonconverged compromise point in the standard; there are minor differences in the FASB and the IASB definitions of “probable.”

For those who aren’t yet familiar with how the new rules will roll out, we are expecting the new standards to be effective for fiscal years beginning after December 15, 2016. For most calendar-year companies that means 2017, and one year later for private companies. With a retrospective presentation of prior periods, companies will be considering and evaluating the new revenue recognition rules for 2015, 2016 and 2017 transactions—which gives them 2014 (one year—next year!) to figure out how they’re going to track this. Alternatively, companies may elect to apply a modified retrospective approach by recording the cumulative effect of the change and providing supplemental disclosures for comparability of prior periods.

Whichever approach companies take, it will be a significant endeavor with complex arrangements. This change will require support from more than just the accounting team. For example:

  • Evaluating and refining IT systems to support the new revenue recognition process and considerations
  • Updating sales team tools and legal business forms
  • Enhancing accounting processes to document the basis for judgments made
  • Designing internal control procedures to address new risks under the new rules

At the end of the day, the global convergence of revenue recognition rules should provide more flexibility in how companies do business. But they don’t remove their responsibility to ensure consistency of accounting and reporting across industries.

Editor’s note: ComplianceWeek interviewed Diana for its article on the new rev rec rules in today’s edition. (Subscription required.)

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Stock compensation rules mask true operating performance

The other day a client asked which current accounting requirement is the worst from a U.S. GAAP standpoint. There are a few poor standards out there, but to me the answer is easy: FAS123R, now known as ASC 718, accounting for stock compensation. It’s been around eight years, and it’s not getting any better with age!

The idea of FAS123R, which replaced stock compensation rules under APB 25, is that all stock grants have a value to the employee, and that should be accounted for as compensation. Consequently, on each stock option grant, there’s a charge to expenses over the vesting period of the grant. Under APB 25, a charge arose only when the fair value of the grant was greater than the grant price, so most grants did not give rise to a charge. Under FAS123R, the expense varies depending on a number of factors, the two most important of which are the fair value of the stock at the time of grant and the volatility of the stock.

Here’s why I think the FAS123R is a bad accounting standard:

Inconsistent and arbitrary outcomes. Take two similar companies: Company A’s stock price is $10 and Company B’s is $5. Both grant an employee 1,000 stock options vesting over 4 years. All else being equal (stock price volatility, expected life of the stock, dividend yield and risk aspects), under the current methods, Company A’s amortized stock charge is double the charge for Company B. That makes no sense. Why does a higher stock price at the time of grant give rise to a bigger charge? If anything, the grant in Company B should result in a bigger gain, as any gain will be a higher percentage of its stock price than for Company A.

The bottom line: the charge is misleading and arbitrary no matter how you look at it. If the stock price rises, that is the real compensation, but the true gain is not reflected anywhere.

In the same vein, if the stock price stays flat or decreases, the employee would have no gain and would not exercise the option. In effect, the grant recipient is not receiving any compensation, so there shouldn’t be a charge to the accounts as FAS123R requires.

Sticker shock. The inclusion of the charge can make a good operating performance look average or poor, and the charge can vary a lot from period to period based on what is happening with the company’s stock price.

Doesn’t reflect reality. You have to ignore the charge to get a good view of the underlying business. Analysts back the actual and expected charges out of their models so they can look at them on a cash basis. If they don’t need to see the charges, why do we? More and more companies are presenting adjusted EBITDA in their earnings press releases. These calculations back out the FAS123R charge for exactly the same reason analysts do—it’s a meaningless charge that mathematicians like but that users of accounts don’t need.

Most private companies ignore it. Who can blame them? There is no value added in accounting for it, and all it does is cost money in systems, review of the numbers and so on. An audit adds even more expense.

It makes budgeting hard. Have you ever put together an annual plan with FAS123R charges in it and then tried to hold people accountable to their budgets? It’s not easy, and most people won’t do it.

If you do want to do it (and it makes sense to have budgets that align to your financial accounts), to estimate the charge you need a crystal ball to estimate your future stock price at the time of the future grant, which you then need to combine with your estimated stock grants and headcount changes, as well as the residual charge from previous grants that are still vesting.

As a CFO, if someone asked you what your stock price will be in 6 months’ time you’d never answer (unless you enjoy SEC investigations), so why make this prediction internally to calculate the expected charge? And it’s impossible to hold managers accountable for their actual charges against the budgets for that expense. It’s also not wise to tie compensation to managing budgets if you have FAS123R in the compensation—at the end of the year the manager will be very happy or very unhappy, depending on which way the variance goes based on events totally out of their control.

So what’s the solution?

I believe FAS123R in its current form should be scrapped, and that only real gains, at the time of exercise, should be accounted for, and only in the notes to the accounts. By removing that expense from the accounts, you can then analyze, assess and compare companies based on their true operating performance, not some arbitrary performance.

Unfortunately, I don’t see any changes taking place soon—but the fact that more and more companies produce numbers that exclude FAS123R charges says that the FASB has gone too far in the accounting requirements, and that accounts are becoming more meaningless when presented under GAAP. Getting rid of FAS123R charges from the income statement would be a good first step to more meaningful accounts.

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