Cash vs concept

You need not stop there. Delve into almost any major corporate controversy of the past 20 years and the question of revenue recognition is likely to be close to the action; and where controversy descended into scandal it’s odds on.

Take some of the UK’s most memorable foul-ups in that period – technology services provider Quindell, small-business financier Versailles, or parts distributor Aero Inventory – or even the undisputed world champion of corporate fraud, US energy trader Enron; what they all had in common was that revenue recognition helped them peddle the illusion they were making huge profits.

As to how, in a way that should be obvious – the accounting rules for revenue recognition allow a company to do what it says on the can, to recognise revenue. From the revenue so recognised in a company’s income statement (formerly the profit-and-loss account), it is just a short step to pulling out profits. And the wonder of it all is that neither a penny nor a cent of the profit needs to be in cash. Thanks to revenue recognition, companies can declare marvellous profits without ever generating any leftover cash.

Perhaps that should not be too surprising since revenue recognition is one of those areas where the rules of accountancy seem to depart from the reality of life. After all, how can there be profit without cash? Short answer, because – like so much else in accountancy – profit is a concept.

Yet accountancy’s concepts aim to paint a more faithful representation of the truth than reality ever could. The concept of profit – and the recognised revenue needed to generate it – falls out of one of accountancy’s fundamental ideas – the so-called ‘matching principle’. This is a notion that traces its origins back to 15th century Florence, the dawn of capitalism and the invention of double-entry book-keeping – that, in keeping monetary score of any enterprise, where there is an asset there is a counter-balancing liability; and, closely related to that, where there is revenue in an accounting period, it must be balanced by the costs incurred to produce the revenue.

However, because accountancy aims to be an essentially-cautious practice, a caveat is due – revenues and costs are matched, but only as far as possible. The matching principle has a superior which says that costs must be accounted for as soon as they are incurred, while the recognition of revenues depends on five linked factors. These are:

●  The risks and rewards of a transaction have been passed from the seller to its customer.

●  The seller no longer has any control over what it has sold.

●  The seller is confident it will receive payment.

●  The amount of revenue can be reasonably measured.

●  The cost of earning the revenue can be reasonably measured.

That means revenues may lag costs. However, meet those factors and revenue can be booked and – perhaps – profits stoked. True, the cash isn’t exactly incidental. It should be there or thereabouts and in most companies most of the time it arrives close to the time of the transaction. Yet in some companies – especially those that make a crust by fulfilling complex projects that may run for years – the timing of incurring costs, booking revenues and receiving cash is likely to be anything but simultaneous, such that revenue recognition becomes a big issue.

For equity investors, the key points to grasp, which we will explain and illustrate as we go along, are twofold:

●  First, when a company books revenue before it receives cash payment then it is creating an asset on its balance sheet – usually labelled ‘receivables’ – and, most likely, profits in its income statement. That may look good, but the corresponding drawback is that the company will need extra finance to cover the cash payments due; in other words, ‘working capital’ rises, sometimes substantially so. Worse, the directors’ estimates of revenues due or – more likely – costs incurred may turn out to be wrong, so the cash profits never materialise; the company may have been running on an illusion.

●  Second, when a company receives cash up-front for work that it has yet to deliver then, in effect, it receives an interest-free loan and an obligation to meet its side of the customer agreement, which it books on the liabilities side of its balance sheet as ‘deferred revenue’ or something similar. This also means that profits are deferred, which may not flatter the income statement in the first instance, but it is healthy for the company’s finances. As such, deferred revenues – and profits – are often a sign of strength.

IFRS 15

Against this backdrop comes a new accounting standard whose specific aim is to “enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts”. That’s a big ask, so a lot rides on 'IFRS 15 Revenue from Contracts with Customers', which came into force at the start of 2018 and is especially important for companies in the capital goods sectors, as we will see shortly.

However, depending on the nature of transactions, other accounting standards dictate revenue recognition. Burford Capital, for instance, relies on 'IFRS 9 Financial Instruments'. This says that Burford’s ‘investments’ – the capital it has sunk into lawsuits – are recorded in its accounts at ‘fair value’. Generally, that is an estimate of a price that would be agreed between a willing seller and buyer. So, for any given case that Burford has funded, it is the theoretical price that someone would pay for the right to the settlement monies discounted for time and risk. In addition – and importantly – changes in fair value from one year to the next are taken in its income statement as profits or losses.

Burford’s bosses acknowledge that, given the complex nature of its investments, “the estimation of fair value is inherently uncertain”. They add that they are “sceptical about predictions and deeply reluctant to try to make them”. Despite that, they have produced estimates of the fair value of cases that, in aggregate, have been the major factor behind Burford claiming an 11-fold rise in investment profits from $30m to $350m in the five years to the end of 2018 even while the cash generated by operations moved from a $44m inflow in 2013 to $198m outflow in 2018 and the cumulative outflow in the five years 2014-18 was $363m.

Perhaps Burford did not have to use IFRS 9 – or its predecessor accounting standard IAS 39 – to assess the lawsuits it funds. Supplying the capital that plaintiffs use to pursue a claim is an investment of sorts. But it might also be viewed as a long-term contract between a finance provider and a client plaintiff, where funding is supplied periodically, costs are taken as incurred and revenues recognised at specific stages. In which case, Burford’s portfolio – and the profits derived from it – might be assessed using IFRS 15, or its predecessor standard IAS 39, which dealt with revenue recognition in a less specific way. Had it done so, Burford’s income statement would not be bulging with profits, and the bubble in its share price – if, indeed, it turns out to be a bubble – may not have inflated and so on.

Only time will tell whether IFRS 15 will spare investors from the consequences of revenue systematically booked too soon. The most recent major corporate failure of a company whose accounts would have been extensively affected by IFRS 15 is construction group Carillion, on which the banks pulled the plug in early 2018.

Carillion: Making tomorrow a better place?

Carillion – corporate motto, ‘Making tomorrow a better place’ – made tomorrow lousy for investors when it collapsed into what is the UK’s biggest ever liquidation in January 2018. With the benefit of hindsight it seems relatively easy to explain Carillion’s demise as a dash to secure construction contracts with too many bids at prices that, in the long run, weren’t profitable. As the last chief executive before its demise, Keith Cochrane, admitted: “We were building a Rolls-Royce, but only getting paid to build a Mini.”

But at least two years before the end, Carillion had become a favourite stock to be short sold by hedge funds, which had got wind of its financial difficulties. Revenue recognition, if not central to these, was certainly involved. As time went by, Carillion was recognising increasing amounts of revenue from construction contracts before it received payment. This is shown in Table 1 as ‘Due from customers’, which rose by three-quarters between 2012 and 2016 from £344m to £615m. Simultaneously, the amounts that were due to customers – where Carillion had billed customers in advance of contract work done – was shrinking.

Table 1: Carillion – key financials

Source: Carillion report and accounts

In crude terms, the change from one year to the next in the net amount between what was due from and due to customers went into the income account as revenue and thence to help produce accounting profits. To explain, the net amount between what was due from and due to customers was £324m in 2015 and £558m in 2016 (see Table 1). So the change during 2016 – £234m – was the amount by which revenue could be raised. As Table 1 also shows, the amounts were often material in relation to the operating profits that Carillion declared. In 2016 – the final year for which there are accounts – the revenue uplift from revenue recognised before it was billed was almost twice operating profits: £234m against £118m.

However, for a company that was implicitly booking a lot of profits before cash came in, the conversion of accounting profits into cash looks quite respectable. It was 68 per cent in Carillion’s final accounts – £80m of operating cash inflow against £118m of operating profits – and it averaged 75 per cent in the three years 2014 to 2016. Yet appearances can be deceptive because the reasons for this acceptable cash generation may have much to do with the superhuman efforts that Carillion’s finance team was putting in to manage the group’s working capital. This, too, is connected to revenue recognition.

For a construction group undertaking long-term contracts often requiring much upfront commitment, Carillion operated with little working capital. Often its current liabilities exceeded its current assets – for example, to the tune of £316m in 2008 and £413m in 2009 – which meant that, in effect, it was receiving interest-free loans from its creditors to finance its short-term assets. The biggest amount of working capital it required at any year end in the 12 years 2005 to 2016 was £52m.

Ostensibly, this is good. Getting creditors of one sort or another to fund a business usually means cheap finance and Carillion’s minimal needs for working capital largely explains why it turned such a high proportion of accounting profits into cash. Yet most likely Carillion was, in effect, part-funding itself with back-door loans. At least, two lines in a note to its accounts deserve close attention.

The first is ‘Accruals & deferred income’, which is the same as the ‘deferred revenue’ we encountered earlier. Somehow – presumably via long-term contracts that it had signed – Carillion was taking money upfront for services it had yet to provide. True, in a sense that deprived it of profit, but it did produce a steady level of interest-free funding through the years, as Table 1 shows, peaking at £421m in 2013.

Second – and more obscure, but also more interesting – is the issue of Carillion’s so-called ‘reverse factoring’. In 2012 Carillion caused ripples – and quite likely attracted the attention of hedge funds – when it announced that, henceforth, it would not pay its suppliers for 120 days, an unusually long period that could well cause them problems. No matter, however, said Carillion because it had arranged reverse factoring whereby banks would pay the suppliers earlier and Carillion would foot the factoring fee for doing so.

One effect of this was that the factoring charge would eat into Carillion’s profits. However, management might well have thought that was a price worth paying because the benefit of reverse factoring was that, in effect, Carillion was borrowing without the debt showing up on its balance sheet. The amounts involved were secreted somewhere in current liabilities – Carillion never did say where – most likely in ‘Other creditors’ (see Table 1 again).

But the real beauty of the move was that changes in the reverse-factoring obligation from one year to the next went through the cash-flow statement as an operating cash inflow. This meant that they worked wonders for Carillion’s conversion of accounting profits into cash. They boosted operating cash flows in each of the four years 2013 to 2016 and, for instance, added £199m to cash flow in 2016. Other things being equal, had the change in creditors been treated as an increase in debt – which, arguably, it should have been – then Carillion would have shown a £119m operating cash outflow in 2016 instead of the inflow of £80m.

Carillion went bust just before companies needed to account for contracts using IFRS 15. Had it adopted the new standard, who knows what truths would have been revealed. Yet in the final set of interim results before its demise, Carillion touched on IFRS 15. Adopting the standard, it said, would cause £100m of retained profits to be written off – presumably overstated by that amount in the past.

Petrofacts

Meanwhile, we can get a handle on the impact of IFRS 15 by looking at companies in similar lines of business. One such is energy-industry contractor Petrofac (PFC), which has been in its own scrapes. It has lost over $500m on contracts in the North Sea and Romania. Worse, it is under investigation by the Serious Fraud Office in connection with allegations of bribery on several contracts in the Middle East, its former head of global sales has admitted bribery charges and the company faces multi-million-pound compensation claims from shareholders. With all this on its plate, we can imagine that Petrofac would adopt IFRS 15 as conservatively and as conscientiously as possible.

There are three aspects to consider: first, IFRS 15’s impact on restating past profits; second, its impact on the latest year’s profits (ie, its effect on the income statement); third – and probably most important – its effect on the balance sheet. That’s the most important because IFRS 15 is chiefly about showing clearly the accumulated ‘store’ of timing differences between revenues billed and cash received in respect of contracts, and this is shown in the balance sheet. It is the store that will be unwound in coming years, generating cash and – to a much smaller extent – profits that are recognised only after cash is received.

All told, applying IFRS 15 knocks $62m off Petrofac’s retained profit, a modest amount in relation to the $882m of retained profit with which it started 2018. Of that $62m, $41m relates to the effect of using a different method of revenue recognition – the ‘input’ method as opposed to the ‘percentage of completion’ method, which Petrofac previously used but is not allowed by the new standard. The input method allows revenue to be recognised in relation to inputs that have been satisfactorily performed, such as labour hours expended or costs incurred; although the accounting standard itself warns that there may not always be a direct relationship between input costs and the transfer of control of what is being supplied to the customer.

In addition, Petrofac trimmed $21m from retained profit in relation to past income that remains subject to various claims and incentives, so-called ‘variable consideration’. Again, the reason was adopting a different accounting treatment. Instead of management using its best guess of amounts forthcoming when it was considered probable that money would be paid, the new standard demands the appearance of more rigour. Hence Petrofac is now using the sum of the weighted probabilities of the consideration due.

As to 2018’s figures, Petrofac did not re-state its 2017 numbers to take account of IFRS 15, so the chief statements of account don’t compare like with like. True, a note to the accounts does show 2018’s income statement and balance sheet both in IFRS 15 format and under the old relevant accounting standard, IAS 18. But, in all, it makes for slightly messy interpretation.

That said, using IFRS 15 raised revenue by 6 per cent from what it would have been under the old standard – from $5.49bn to $5.83bn. That had a magnified effect on profits. At the operating level they were 77 per cent higher than they would have been – $159m compared with $90m – and pre-tax they were $107m compared with $38m.

More important, though, is to see the balance sheet remodelled by IFRS 15. The chief effect is that contract assets and contract liabilities are drawn from a mix of accruals and deferrals that were previously on the balance sheet or tucked inside its notes. To reiterate, the contract assets are where the company has booked revenue – and implicitly profits – upfront with the cash to follow; the liabilities are where the billings have been made, or cash has been received, upfront with the revenue – and profits – to follow. Table 2 shows the details.

From a mix of ‘work in progress’ and ‘receivables’ under the old format, Petrofac draws almost £2bn-worth of contract assets into its current assets (for what it’s worth, there is another £40m in longer-term assets). The italicised data in Table 2 shows that work in progress was pretty much a straight switch from the face of the balance sheet to a note within contract assets. Meanwhile, the balance of the contract assets were drawn from items previously classified as receivables.

Table 2: IFRS 15's impact on Petrofac's balance sheet

Source: Petrofac 2018 annual report. Note that neither assets nor liabilities is a complete schedule, so numbers don't sum or balance. Entries in italics show data only available in notes to the accounts so there is no data for 2018 under the old accounting standard

On the liabilities side, there is almost a straight switch from ‘billings in excess of costs and estimated earnings’ under the old format to ‘contract liabilities’ under the new. The notes to the accounts helpfully split the contract liabilities into advances from customers (£130m) and billings in excess of costs (£374m).

Also worth noting – since it affects revenue recognition – is £1.65bn of accrued expenses. In effect, these are loans – most likely from sub-contractors – since they represent expenses that have been charged to Petrofac’s income statement but not yet paid. The drop of £311m from £1.96bn in 2017 to £1.65bn is because Petrofac received higher milestone payments in 2018. However, the accounts give no clue as to why the drop is much lower under IFRS 15 than the old accounting standard.

What we don’t get in Petrofac’s accounts is a comparison of 2018’s cash flow statement under the old and the new standard. Presumably that’s because – as theory says it should be – there is no difference between the two; applying new accounting rules will have no effect on cash flow. Certainly, Petrofac’s net debt at the end of 2018 remains the same under both accounting standards at $390m.

No matter. IFRS 15 may yet bring worthwhile improvements to companies’ accounts, revealing more clearly those companies that are truly profitable and those that simply claim to be; those that run on revenues generated by the optimism of their bosses and the docility of their auditors and those that are good enough to be profitable even while receiving lots of cash upfront. In other words, it will help to sort the wheat from the chaff. But that will only be revealed over several years of producing comparative figures from one year to the next. And that process has only just begun.