Revenues Will No Longer Be the Same
Thursday, June 5, 2014

Sometimes a sale isn’t a sale. Under accounting rules, the date when a company can record revenues depends on what it sells. A change to rules will simplify matters and change how revenues are booked by a broad range of companies. In the process it will alter valuations and growth rates.

It’s a big change. Even if you view accounting rules as exciting as reading the phone book, you should be spend some time familiarizing yourself with the new rules. I’ll try to make the discussion as least arcane as possible.

The new rules are the result of the work by the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) to establish a unified stance on when companies should recognize revenues. Here is how the IASB and FASB described the change:

“The core principle of the new standard is for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration (that is, payment) to which the company expects to be entitled in exchange for those goods or services. The new standard also will result in enhanced disclosures about revenue, provide guidance for transactions that were not previously addressed comprehensively (for example, service revenue and contract modifications) and improve guidance for multiple-element arrangements.”

The Wall Street Journal used mobile phones to describe how the rule change will impact reported revenues, and I’m going to do the same. Currently, you can buy an iPhone 5C from AT&T (T) for $99. The price is subsidized and AT&T recoups the difference between what you pay and the wholesale cost of the phone over the life of the two-year contract you sign. Under current rules, AT&T has to book its cost of the phone at the time of the sale, but recognize the revenues for the phone over the life of the contract. The new rules will allow AT&T to recognize more of the revenues related to the phone at the time of sale.

The new rules will have the reverse effect on companies when a sale bundles multiple transactions. The Wall Street Journal used auto manufacturers as an example, and I’ll again follow their lead. If a new car is sold with a warranty and free maintenance for a period of time, an automotive company can currently book all of the revenues at the time of the sale. Over a period of, say, three to five years, the customer may come back to the dealer to get an oil change or have a faulty starter motor replaced. To better match these costs to the revenues received, automotive manufacturers will have to spread the recognition of revenues from the sale of a vehicle over a longer period of time.

The short-term impact should be lower margins for companies bundling the delivery of future goods and services with the initial sale (e.g., automotive and appliance manufacturers offering warranties or maintenance packages). The new rule should boost short-term revenues for companies having lower future costs related to the initial sale (e.g., wireless providers and software companies). The rule could also lead to more volatility in revenues and earnings depending on the cyclicality and seasonality of a business. There may even be a period of time between now and the proposed implementation date of 2017 when companies report two sets of numbers to show the impact the new rules will have.

Long-term, the new standard should be beneficial since it will better reveal how profitable a corporation is.

More on AAII.com

The Week Ahead

The only S&P 500 member scheduled to report is H&R Block (HRB), which will announce its results on Wednesday.

The first economic reports of note will be released on Thursday: May retail sales, May import and export prices and April business inventories. Friday will feature the May Producer Price Index (PPI) and the June University of Michigan consumer sentiment survey.

The Treasury Department will auction $28 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday.

Two Federal Reserve officials will speak on Monday: St. Louis president James Bullard and Boston president Eric Rosengren.

What’s Trending on AAII

  1. The Three Pockets Approach to Investing
  2. Strategic Value Investing: Screening for Cash Flow and Value
  3. Making Effective Use of IRAs as Part of an Estate Plan
AAII Sentiment Survey

Optimism among individual investors is above its historical average for the first time in 12 weeks. At the same time, neutral sentiment fell below 40% for the time in six weeks.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 3.0 percentage points to 39.5%. This is the first time optimism is above its historical average of 39.0% since March 13, 2014.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 2.1 percentage points to 38.3%. This is the first sub-40% reading since April 24, 2014. Nonetheless, neutral sentiment remains above its historical average of 30.5% for the 22nd consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 1.0 percentage points to 22.2%. The drop puts pessimism below its historical average of 30.5% for the seventh straight week.

The spread between bullish and bearish sentiment (the “bull-bear spread”) widened to 17.3 percentage points. This is the largest bull-bear spread since February 27, 2014.

This week is the first time bullish sentiment has exceeded neutral sentiment in three months (since March 13, 2014). During the past three weeks, optimism has rebounded by a cumulative 9.1 percentage points, while neutral sentiment has declined by a cumulative 4.9 percentage points. Neutral sentiment is now back within the typical range of its historical readings (less than one standard deviation from the mean), though near the upper end of the typical range.

The resilience of the S&P 500 index and its record highs is likely playing a key role in boosting optimism among individual investors. Also helping are continued signs of economic expansion, the Federal Reserve's tapering of bond purchases and low interest rates. Offsetting this optimism is the pace of economic expansion, Federal Reserve tapering and frustration with Washington politics. Though neutral sentiment has pulled back, many AAII members still remain uncertain about the short-term direction of stock prices or expect stocks to remain essentially unchanged over the next six months.

This week’s special question asked AAII members what industries or sectors they like right now. Energy was the most the popular, picked by nearly a third (31%) of all respondents. Technology and health care tied for second, with each named by approximately 18% of respondents. Industrials were third, picked by about 13% of all respondents.

When we asked the same question in January, respondents said (in order of popularity) health care, technology, banking and finance, and energy.

This week’s Sentiment Survey results:

Bullish: 39.5%, up 3.0 points
Neutral: 38.3%, down 2.1 points
Bearish: 22.2%, down 1.0 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%

Take the Sentiment Survey.
AAII Asset Allocation Survey

Cash allocations rose to an eight-month high last month, according to the latest AAII Asset Allocation Survey. Individual investors reduced their equity exposure, while holding their fixed-income allocations relatively steady.

Stock and stock fund allocations fell 1.7 percentage points to 65.3%. This is a six-month low. The decline was not steep enough to prevent equity allocations from remaining above their historical average of 60% for the 14th consecutive month and for 16 out of the past 17 months, however.

Bond and bond fund allocations declined 0.1 percentage points to 15.5%. The decline put fixed-income allocations below their historical average of 16% for the third consecutive month and the fourth in the past six months.

Cash allocations rose 1.8 percentage points to 19.2%. As noted above, this is the largest allocation to cash since September 2013 (19.6%). Even with the increase, May was the 30th consecutive month with cash allocations below their historical average of 24%.

The reduced exposure to stocks and stock funds occurred as the proportion of individual investors describing their six-month outlook for stocks as “neutral” in our weekly Sentiment Survey stayed above 40% for five consecutive weeks. Equity funds saw the biggest decline, with allocations declining by 4.1 percentage points. Though some of this drop is partially due to having a different group of AAII members take the Asset Allocation Survey in May than in April (there were likely some members who took the survey during both months), the Investment Company Institute estimates show equity funds experiencing $6.0 billion of net outflows during the first three weeks of April. While there is uncertainty about the short-term direction of stocks, the drop in yields has hurt the attractiveness of bonds to income-seeking investors.

June’s special question asked AAII members when they last changed their portfolio allocations specifically because of their age. Nearly a third of all respondents (32.3%) said that they have never changed their allocations, or that they have never changed their allocations specifically because of their age. Slightly more than 14% changed their allocation due to their age five or more years ago. Approximately 22% altered their allocations as result of their age within the past 18 months. Many respondents said they altered their allocations at retirement and have not changed their allocation due to their age since.

Here is a sampling of the responses:

  • “At age 65, I dropped from 70% equity funds to 60% and plan to keep between 50% and 60% in equities forever.”
  • “We began investing in dividend-paying stocks and increasing our cash position upon retirement, approximately 15 years ago.”
  • “Specifically because of age? The year I retired.”
  • “Never because of age. I only change my portfolio based on the market.”
  • “Never have. Pension, Social Security and rental incomes cover my expenses, so I have not had to adjust my stock and bond allocations.”
  • “I will shift my allocation to a standard when my brain no longer can analyze the markets.”

May Asset Allocation Survey results:

Stocks/Stock Funds: 65.3%, down 1.7 points
Bonds/Bond Funds: 15.5%, down 0.1 points
Cash: 19.2%, up 1.8 points

May Asset Allocation Survey details:

Stocks: 35.1%, up 2.4 points
Stock Funds: 30.2, down 4.1 points
Bonds: 3.7%, up 0.7 points
Bond Funds: 11.8%, down 0.8 percentage points

Take the Asset Allocation Survey.

Archives

May 29, 2014: The Difference Between Stock Screens and Portfolios

May 22, 2014: Not Updating Your Beneficiaries Can Be Costly

May 15, 2014: Blocked From Buying and Selling Mutual Funds

May 8, 2014: Insights from the CFA Conference