GE Has A Problem With The Way It Recognized Revenue From Long-term Service Agreements

On October 30, 2018, Reuters published an on-line article titled General Electric reveals deeper regulatory probe, restructuring.

In the section titled INVESTIGATION DEEPENS, the article reported:

 GE has said it learned of regulatory scrutiny last November, when the SEC said it was investigating GE’s accounting for long-term service agreements. 

And while an investigation does not mean proven guilt, the subject of accounting for long-term service contracts has been the subject of the 2014 issuance of new US and International Accounting Standards.  

Specifically, the United States Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB)jointly issued Accounting Standards Codification (ASC) 606, regarding revenue from contracts with customers. These changes are in effect now for public companies and in November 2018 for private ones. The impact of ASC 606 is on enterprises selling multi-year contracts or including such contracts as part of multi-year operating leases.

On October 8, 2018, Ron Giuntini and I published an article about these new accounting rules.  In that article, we explain the ”old” way to recognize contract revenue as:

Your accounting department will typically have an Excel spreadsheet which lists each contract in the left-most columns and each month across the top row. They may recognize the revenue by dividing the total contract value into 12 equal cells and at the end of each month move one-twelfth of the contract into the monthly revenue account. That movement is called revenue recognition. The assumption of such calculations is that costs are in fact “exactly” aligned with revenues.

This method works when the total annual revenues  recognized of contracts-in-force  are not “material” to the financial results of the business; this means that contract revenue is significantly less than 5% of total revenue. And, of course, this method fails to attempt to match revenue and expenses in the same time periods but again it is not material to the shareholder’s decision making.

Note that “materiality” does NOT consider profitability, only revenues. As a result, there is an  assumption that contracts have the same profit margins as that of the sale of a product, which is a false assumption; contract profit margins can be anywhere from 50% to 200% higher than that of products. So is employing the financial accountant’s “materiality” assumption of often “ignoring” contract oversight the right path to pursue?

But what happens if the contract revenue is deemed material by leadership?  One possible outcome is that someone in the enterprise can decide to “play games.” For example individuals can recognize contract revenues before or after a performance event, the driver of revenue recognition, in order to craft a more favorable overall revenue picture.  Over the life of the contract such “games” may not change overall revenue recognized, BUT it can materially impact short-term KPIs.

As we wrote in our article:

ASC 606 provides a uniform framework for revenue recognition from multi-contracts. The core principle of ASC 606 is that revenue is recognized when the delivery of promised goods or services matches the amount of consideration expected in exchange for the goods and services. In other words, we now only recognize revenue where there is an offsetting expense in the same period.

Let us look at three examples of the materiality of service revenue (mostly multi-year contracts) to GE business segments as reported in their 2017 Annual Report.  (All numbers in US$ Billion):

In the three business segments of the example, service revenue (frequently multi-year service contracts) is definitely material.

The outcome will be very interesting when the SEC completes its investigation and reports it's findings.  Until then, I do not believe there is anything further to say other that Good luck, GE. 

Update:  After this article was posted, a PhD Accounting Professor friend of Ron Giuntini told him that break/fix events in a contract can be treated like insurance; you can straight line its revenue recognition. 

As for planned maintenance activities, they are event based and must be treated as described in this article.  However, if the contract is closing-in to its end, you don't have to recognize the revenue until the contract is closed and then make your adjustments in that financial period.

The key is that whatever approach you take it is presented to the auditors who want to have an audit trail of how you recognized revenues during the life of the contract.

Also, it appears that 2-3 year contracts have much less rigorous revenue recognition reporting than that of a 4+ year contract.