Volume 23, No. 10: Revenue Recognition: How It Will Change For Three Key Sectors
“Predicting is hard, especially about the future.”
Yogi Berra may have said it first, but he’s right: predicting the future is hard. Ask anyone who works on Wall Street for a living, someone who traffics in estimates of a firm’s worth based on its future earnings. Before they even arrive at earnings estimates, they have to predict – or try to predict – revenues, and often their predictions are helped through “guidance” provided by management. That guidance can be reasonable or unreasonable, and it’s up to the analyst to decide. “Reasonableness” depends on an analyst’s knowledge and experience.
In 2017, the rules change on recognizing revenue for U.S. companies. Will those changes speed up reporting of revenue – or slow it down? When it comes to assessing the effects of the changes and the veracity of the guidance managers provide about revenues, investors and analysts will be at the mercy of those guidance providers. Forewarned is forearmed: investors and analysts need to have at least a rough idea of how the new rules might change reported revenues, so they can make better estimates. At the very least, maybe they can better assess management guidance.
While it may be hard to predict the future, applying logic and facts to a puzzle can make it look like you’ve predicted the future. Here, the new revenue recognition standard’s requirements are applied to facts about present-day revenue recognition practices for firms in three sectors: technology, telecommunications and health care, so as to predict the change’s effects. Those three sectors are perhaps the most interesting because the new standard will likely drive a wider wedge between earnings and cash flows, and pro forma earnings reports are common in those sectors. Yet pro forma reporting neglects the real differences between earnings and cash flows, creating a bigger investor blind spot.