Publicly traded companies are mandated by the Securities and Exchange Commission (SEC) to report their recognized revenues in quarterly earnings reports and in annual SEC 10K reports. If an audit reveals that recognized revenues were not presented accurately, or were not adequately documented, the company may be directed by the SEC to restate earnings, an exercise that can be very costly, and that can result in jail time for executives.
Since contractual agreements with suppliers and customers drive earnings, improved contract process controls— and enhanced management of contracts— are both essential for preventing exposure to restatement risks. Yet, all too often, companies view contract management as a tactical solution, not a strategic one. As a result, top level executives seldom get involved in purchase decisions, and, even less frequently, drive such projects. This is an unfortunate situation since more robust adoption of contract management software could provide sizable strategic benefits to any public company. These include the following:
- an improved public image;
- dramatically reduced costs associated with generating earnings reports;
- more complete and easily accessible documentation to support earnings statements;
- greater internal visibility to the revenue information required for optimized business management;
- an ability to more easily implement contract process controls.
But perhaps the most significant strategic benefit of contract management software is its ability to help companies prevent a potentially devastating loss of reputation and pubic confidence that may accompany an earnings restatement. Eliminating this risk is so significant, that it alone may justify an investment in a contract management solution.
A Changed Perspective
In recent years, the credibility of earnings statements as a way of providing visibility for shareholders and potential investors in public companies has been severely impacted by well-publicized abusive practices. In response, corporate executives are now required to attest to the veracity of these reports, and risk jail time if inaccuracies are revealed. Needless to say, the result has been that most companies are now taking their corporate responsibilities more seriously.
From the public’s perspective, a renewed focus on the importance of accurate earnings filings has had other impacts. For example, in the shadow of Enron, WorldCom and other such debacles, there is now a preoccupation among the investment community with earnings. The result is that whereas in the past companies always tried to present the best possible spin on their earnings, now, when companies appear to be doing too well, investors may set off an alarm that results in an earnings audit. This may cause companies to err on the side of safety. Of course, if taken too far, such caution may expose companies to the risk of understating earnings, and again, create restatement risks.
It is also interesting to note that to prevent an erosion of public confidence, companies are increasingly initiating their own audits to see if restatements are necessary. An internal audit, for instance, may reveal that a company lacked supporting documentation for certain recognized revenue sources in a quarter. Instead of simply hoping that the oversight is never caught, the company may decide to proactively prove they are good corporate citizens by restating earnings—and avoid the risks associated with an SEC mandated restatement.
In other words, in the current business environment, significant benefits can accrue to the company that emphasizes earnings accuracy and works diligently to hone an image of honest disclosure. The situation here is analogous to an affirmative defense, a legal technique that can eliminate culpability for an obvious wrong-doing if a company has clearly implemented controls to prevent that wrong-doing. According to this legal strategy, even if there has been a breach of the control, the very fact that the control existed may mitigate liability.
The message is clear: with cultural, political, and financial pressure to ensure earnings accuracy, companies that fail to implement appropriate controls are likely to find themselves at a disadvantage in the marketplace.
Potential Restatement Costs
If conscience, public confidence, and shareholder value are not reason enough to avoid earnings restatements, then consider the fact that managing the impacts of earnings restatements can be nightmarishly costly if left unchecked. Take the case of a company that over-stated earnings two years ago by $100 million, and then budgeted that amount for increased staffing and R&D. As a result of the restatement, lay-offs may be required which can cause new programs to come to a grinding halt, new products fail to reach the marketplace, and the company’s stock price begins to slide.
Of equal concern are the actual costs of restatement. Most companies try to get earnings statements right the first time by throwing a virtual army of staff at the task. At larger companies this may mean having hundreds of employees spending two to three weeks every quarter reviewing all contracts manually to compile the information required. The magnitude of this task is increased by the fact that revenue recognition may originate not just from contracts signed in the current quarter, but from those signed in previous quarters as well.
Complicating things further are the various accounting principles applied to revenue recognition. Some products or services may result in revenues being recognized upon contract signing, others may delay recognition until a first shipment is delivered, others may require a series of shipments to be completed, and still others may require payment in full.
Against this backdrop, compiling earnings data when contracts are current or fairly recent is difficult enough. Re-constructing this information when contracts are older, and perhaps expired, is even more complex. Furthermore, with the probability of human errors increasing as the complexity of manual tasks increases, the possibility of an accurate restatement requires even greater diligence the second time around. Lacking an automated contract management system that enables fast and easy access to contracts and the data they contain, this diligence can only be achieved with massive and costly human effort.
Not to be overlooked are the cost implications of restatements to downstream quarters. If Q1 in 2004 needs to be restated, for example, all subsequent quarters may also need to be re-evaluated. It soon becomes apparent that costs rapidly escalate as the impacts of a single quarter’s restatement percolate through the enterprise and prevent staff from performing their day-to-day activities while required data is compiled.
Contracts as the Ultimate Control to Prevent Restatements
The best way to prevent the nightmare of restatement is to implement processes and systems that facilitate fast, efficient, accurate, and documented reports that detail and authenticate recognized revenue quarter-by-quarter. As stated above, the best way to achieve this objective is with an effective contract management solution. With this type of software, data fields, clauses, and language can all be standardized across all contracts to help prevent a wide range of errors that otherwise can derail the best efforts to accurately track recognized revenue.
For example, in one U.S.-based company, a contract worth almost $60 million was scheduled to be included in a second quarter earnings statement since the date on the contract was 03/10/07. Fortunately, one final check revealed that the contract was with European company and rather than referring to the March 10, 2007, the date designated was really October 3, 2007 because European convention reverses the month and date fields as compared to conventions in the U.S. With a contract management solution, date fields can be forced to comply with the any single, enterprise-wide standard. As a result, fields will be consistent across all contracts and errors will be prevented.
Standardization can also prevent revenue recognition errors associated with modification to specific contract clauses that otherwise may be made during negotiations. Contract management solutions can be set up to simply reject any modifications to clauses, or they may be configured such that if modifications are made, the contracts will be automatically routed through an appropriate approval cycle before they can be signed.
Contract management solutions can also cut the time it takes to compile the earnings data required for statements from thousands of man-days, to a few man-hours, eliminating human errors and freeing trained staff to focus on investigating exceptions. This feat is accomplished because the solutions store all contracts and associated metadata in an indexed and easily searchable electronic repository. With these solutions, all contracts, all indexed fields, and all pertinent information pertaining to recognized revenue is instantly available by any authorized user of the system.
Most contract management systems make revenue recognition data compilation even easier with a reporting capability that can automatically generate this information on a pre-determined schedule. Furthermore, some solutions also offer analytics tools that allow data fields to be extracted across any sub-set of contracts, compared, and presented in any format required. As a result, executives can easily monitor contract performance enabling them to optimize revenue recognition strategies.
Some analytics tools even interface with other enterprise applications such as those used for sales, accounts payable, or pricing. By comparing data across these (and other) multiple systems, transaction history can be verified, irrefutable earnings documentation can be obtained, and contract histories evaluated to enable more accurate sales forecasting. This analytics-based cross-functional alignment can also drive control processes that ensure contracts are actually approved before orders are entered, that actual pricing matches order specifications, and that deliveries and revenues meet contract specifications.
Clearly, a contract management solution is a vital tool that can be essential for attainment of corporate objectives. As more and more companies recognize the importance of these solutions for ensuring and validating earnings statement accuracy, the technology is like to snowball, becoming a core operational, tactical, and strategic requirement.