Accountants, auditors, and corporate entities alike, take notice: the exposure draft recently issued by the Financial Accounting Standards Board (FASB) promises that big changes are in store. Weighing in at 170 pages, the proposed new revenue recognition standard is designed to improve and align the financial reporting of revenue from contracts with customers and related costs.

The draft is a joint effort with the International Accounting Standards Board (IASB), and if adopted would create a single revenue recognition standard for International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) to be applied across various industries and capital markets.

The two groups have four objectives for the new standard:

-  Remove inconsistencies and weaknesses in existing revenue recognition standards and practices;

-  Provide a more robust framework for addressing revenue recognition issues;

-  Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets; and

-  Simplify the preparation of financial statements by reducing the number of requirements to which entities must refer.

In a podcast posted on the FASB website, board member Leslie Seidman said the current system was developed over many years on an ad hoc basis, creating a “very complex, inconsistent, and incomplete set of standards.” The proposal, she said, “will make accountants’ jobs easier when new types of business arrangements emerge because they’ll have one standard to look to on how to recognize revenue for the arrangement.”

If both groups can sort through and incorporate the various feedback received – the comment period ends on October 22^nd – the final standard is expected in the second quarter of 2011. Assuming it is adopted, the FASB has produced a chart outlining the five steps companies will need to follow to apply the revenue recognition proposal.

While it still has a long way to go, the new standard represents a significant improvement over the current system. When combined with other projects in the works to reconcile GAAP and IFRS, they will collectively amount to a single set of high quality, global accounting standards.

Earlier this month we wrote about how the new revenue recognition rules are having an impact in the technology sector, but it doesn’t end there. In fact, my colleague Michelle Kupka and I will be leading a webcast regarding the current changes in revenue recognition this coming Tuesday, November 3.  And if there are readers out there who have struggled with rev rec, we’d love to hear your take on whether the new rules will be an improvement - or just another hurdle.

Among the industries that will be affected, life sciences and biotech stand out due to their long R&D cycles, their capital requirements and the infrastructure required to manage and market products from concept to distribution.  This hits home for us in Massachusetts, where the steady growth of the life science and biotech industries depend not just on science and commercialization, but on compliance and a strong balance sheet as well.

A great number of life science and biotech projects are embarked upon as joint development arrangements with pharmaceutical companies or distributors, and as a result, revenue is often generated under complex scenarios.  These arrangements often include payments linked to milestones, upfront payments, joint funding payments, joint product launch funding, licensing of future products developed and other issues. It is these complicated relationships that result in misstated revenue, in turn leading to an above-average rate of financial accounting restatements.

FASB’s new revenue recognition rules take these circumstances under consideration, and in particular they address:

1. whether the arrangement represents a single unit of accounting or multiple units;

2. if the arrangement represents a single unit of accounting, how the revenue should be recognized when such arrangements spans over multiple financial reporting periods; or

3. if there are multiple units, how revenue should be attributed.

Under the new revenue recognition guidance, the elimination of the requirement to establish fair value of undelivered products or services using objective and reliable evidence (replaced by the concept of “Estimated Selling Price”), as well as the elimination of the use of the residual method for allocating arrangement consideration will make things a bit easier and serve to facilitate consistency in revenue recognition accounting for these types of collaborative development arrangements.

While we will begin to see some clarity, vagueness will still persist in certain areas.  On the bright side, due to the life science and biotech industries’ unique approach to collaborative development arrangements and long-term view of success, companies should find some comfort in these new rules.

We recently issued an alert about FASB’s new rules regarding “Revenue Arrangements with Multiple Deliverables” and “Applicability of AICPA Statement of Position 97-2 to Certain Arrangements That Contain Software Elements.”  FASB ratified the standards in late September, and they will cause some shifts in accounting for technology companies.

Before the change, companies that made smart-phones, telecommunications equipment, semiconductor equipment and other related products were required to bundle the hardware in their products with vital software components, and then use software rules to recognize the revenue.  From a business perspective, this raises the potential for a reduction in reported revenue. Companies like Apple, for example, suffered when sales and profits from their iPhone appeared lower (17% and 58% lower respectively) under the traditional system.  CFO Magazine covered this nicely in their September piece, “New Revenue-Recognition Rules: The Apple of Apple’s Eye.”

The new rules allow companies to recognize more of the revenue from a hybrid-type product than before. Unbundling software from hardware allows the hardware sales to be recognized sooner, as software’s revenue is added up more slowly; over the life of the contract or according to the software’s expected life cycle. This is designed to give a more accurate picture of revenue, which can have a tremendous impact on corporate earnings and shareholder value.

The new rules also put the U.S. on par with the rest of the world, which has already adopted the practices. Companies will be required to comply by June 15, 2010 but are allowed to adopt the practice as early as this quarter.

Sounds good right? The change could create a bump in sales and profits in the short-term for the companies affected. However, as described in our September 8th post, the benefits come with a cost: “The new guidance will require enhanced financial statement disclosure – the new EITF proposal includes a four page example of such a disclosure (no, I am not kidding). These additional disclosure requirements will entail both qualitative and quantitative information surrounding the significant judgments involved with multiple deliverable revenue recognition.”

Thus, while the new rules will likely have a positive impact on financial statements, there may be significant leg-work involved in order to get there.