Selling-Price Estimates in Revenue Recognition and Earnings Informativeness*

Abstract:     
Multiple-element firms sell and deliver multiple goods and services across multiple reporting periods (e.g., software, maintenance, and upgrades), in exchange for an aggregate consideration. In reporting revenues from incomplete contracts, those firms often have to estimate standalone selling price of each good/service. I examine whether, on average, those firms’ selling-price estimates enhance earnings informativeness and/or are used to manage earnings. Arguably, firms can misrepresent selling prices to shift revenues across reporting periods. This notion prompted standard setters to promulgate SOP 97-2 to reduce software firms’ flexibility in using selling-price estimates in reporting revenues. I find that implementing SOP 97-2 rules led to a decline in earnings informativeness, but had no discernible effect on earnings management. Thus, my findings suggest that at least in this instance, firms’ selling-price estimates conveyed value-relevant information to investors. My findings support FASB/IASB’s proposal to change standards by reinstating firms’ flexibility in using selling-price estimates in reporting revenues.

Keywords: Revenue Recognition, Standards Setting, Earnings Management, Relevance, Accounting Rules, FASB, IFRS

JEL Classifications: G14, G38, M41, M44, L86

Working Paper Series