C&B Notes

Map Is Not The Terrain

Our job is to understand the terrain.  Standard accounting rules provide a map that approximates the terrain, but the map is not the terrain.  Changing accounting rules will lead us to make different adjustments for different businesses as we seek to understand the real fundamentals of a business.  We watch closely to see (i) if markets significantly change their valuations of some businesses just because of a change in accounting rules, and (ii) if managements change their decisions because of the new accounting rules.

Finance managers at Rolls-Royce Holdings two years ago predicted a plunge in the aircraft engine maker’s 2018 revenue and profit.  Starting Jan. 1, 2018, Rolls-Royce will no longer be able to put money from maintenance contracts on its books years before it begins to do the work.  The company must wait to record that revenue until the actual service is provided, said John Dawson, director of investor relations.  This is typically years after the company sells the engines at a loss.  The change is the result of a new accounting standard that will force businesses in more than 100 countries to rejigger how they recognize revenue.  It is similar to a rule U.S. public companies will have to follow as of Dec. 15.

The new rules come as Rolls-Royce’s order book is growing.  Customers have placed around 500 orders for large engines that include Rolls-Royce’s “TotalCare” maintenance program for next year, up from 450 this year and around 320 in 2016.  When executives at Rolls-Royce recalculated some of the company’s 2015 results using the new accounting rules, both revenue and profit were £900 million ($1.18 billion) lower than reported.  Rolls-Royce started updating investors, analysts and other stakeholders about potential changes to its financials about a year and a half ago, earlier than most other companies.  “We have been proactive in handling this,” said Mr. Dawson.

The new rules will supersede virtually all existing revenue recognition requirements under International Financial Reporting Standards.  A similar change is under way with U.S. Generally Accepted Accounting Principles.  Under both standards, companies will be required to provide more detailed information about their contracts and accounting judgments, some of which they haven’t gathered before…

“The impact will vary, depending on the individual company, their sector and their business model,” said Nick Chandler, a partner at KPMG.  The new revenue standard “requires a far deeper understanding of companies’ contracts than previous rules.  It’s a huge exercise,” Mr. Chandler said. According to the KPMG study, only a small number of firms — 9% — expect the new rules to have a material effect.  Still, all listed companies filing results under international financial reporting standards must publicly disclose that they have assessed the impact.  Deutsche Telekom AG is one company that expects a material change to its financials.  The German telecommunications company’s 2018 opening balance sheet will reflect a one-time increase of €3 to €4 billion ($3.5 billion to $4.7 billion) in retained earnings.  Going forward, the company is expected to post lower revenue in its mobile-service business but higher revenue in its hardware business starting from the first quarter…

Analysts say companies’ impact assessments of accounting rules help them adjust their forecasts.  “In terms of my models, there were many material changes to the numbers in the profit and loss account” for Rolls-Royce, said Sandy Morris, an analyst at Jefferies LLC who covers the company.  Mr. Morris said the company’s disclosures and information sessions “were extremely helpful.”

 

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