Fair Value

I am a corporate CPA and heavily involved in the world of revenue recognition. I know, I know...BORING! I can't blame anyone for reacting with that thought. For those outside the curious little world of rev rec it is, no doubt, boring. For those of us inside the asylum, however, life is never boring.

For those on the outside let me give a brief explanation as to why it is never boring, and then I will delve into the specifics of my thoughts for today.

For a company to survive in the long run it must make more money than it spends--no shocker there. Money is made when products and/or services are sold. In order to make a sale a company generally relies on its sales force. Folks who work in sales are paid on a commission model--the more you sell, the more you get paid. Simple enough so far. Well, a company can do all sorts of things with its commission model to incent its sales force to sell various items with more or less fervor. And, as you might expect, in large companies the commission model can become so complex that occasionally situations will arise where it appears the company is actually rewarding behavior that is contrary to the goals of the organization.

Sales folks are not dumb--like you and me they want to get paid as much as possible for the work they do. So they study the sales plan and the commission model and determine the best way to make the most amount of money. With a good commission model that will result in lots of revenue for the company. However, with a suspect commission model that can result in any number of unforeseen outcomes.

On top of all that you get to layer in Generally Accepted Accounting Principles--GAAP. Truth be told, even insiders often have a difficult time navigating the labyrinthine halls of GAAP revenue recognition. There are so many nuances to the guidance and strata to the guidance hierarchy that for those not trained in the craft a herculean effort is required to gain even a rudimentary understanding of the rules.

What this often leads to is a commission model that makes sense to the lay person and seems to have the best interests of the company (and the sales person) at heart. However, rare is the time that those who derive the commission model understand the havoc that GAAP will wreak on the timing of revenue recognition for any given transaction. Thus, a sales person will think she has made a sale that will net her $30,000 in the quarter. All too often, however, GAAP will require a deferral of the revenue for reasons that will seldom make sense to the sales force. So, you have the never ending friction of the sales person wanting to get a pound of flesh from the accountant, and the accountant wanting the sales person to stop being so self centered and ego centric. Good times! So, it's rarely boring.

My thought for the day is that this is troublesome because it frequently leads to the sales force acting against the best interests of the company. For instance, sales person X might sell a product for 100K and recognize an opportunity to sell additional services with that product. So, X dives in deeper, negotiates with the customer and comes away with two additional services deliverables for another 50K. Company is ecstatic. 100K of revenue now (when the product is delivered) and 50K in the future (when the services are delivered). X feels great because instead of netting 10K in the quarter, he is now netting 15K. Customer is happy because the services are value add and will improve their infrastructure and ability to service their own customers in the long run.

Well, not so fast. Depending on the deliverables and numerous company-internal factors, GAAP may require that the 100K of product revenue be deferred until the services are delivered. So, now there is 0K of revenue this quarter and X receives $0 just in time for Christmas. Once X gets his hand slapped like that one time he learns quickly. Next quarter a different customer wants the same 100K product plus 50K of additional services. X says we can give you the product, but the services are out of scope. Why? He wants his comp today. Maybe he has multipliers in the current quarter, maybe he's buying a new home and needs the $ for the down payment. Could be lots of reasons, but the long and the short is that the company just missed out on 50K of additional revenue over time because the compensation plan was not aligned with GAAP and the various types (and combinations) of products and services being sold.

This is a very high level view of the issue. Lots of layers and arguments on both sides of the issue, but suffice to say that it usually ends up being very messy. Believe it or not revenue recognition is quite a fascinating frontier if you are familiar with the issues. Plenty of work to be done here.