Service revenue not as simple as it sounds

We are seeing more and more operators announcing new handset-financing programs. Part of the reason for this is that they are attempting to move away from the burden of handset subsidies.
 
Additionally, operators may also be preparing for the upcoming changes to the revenue-recognition standard that will, if implemented, have a significant impact on their service revenue.
 
For the sake of completeness, let’s start with the basic definition of total revenue in the telecom industry:
 
Total revenue = Service revenue + Handset revenue*
 
One would therefore assume that all revenue associated with providing telecom services is allocated to service revenue while all revenue linked with handset sales is allocated to handset revenue.
 
If only it were that simple.
 
In reality, service revenue actually includes a part of handset revenue that relates to subsidized handsets purchased on pay-monthly plans. The price that a customer pays upfront for a subsidized handset is recognized as handset revenue. Each monthly payment made by this customer includes a handset component related to the subsidized handset and a services component related to using telecom services.
 
Pay-monthly plan = Monthly service revenue = Handset component + Service component
 
The total monthly payment is recognized as service revenue. The handset part of service revenue is not service revenue in its true sense and inflates the true service revenue. Operators see handsets as a key factor in attracting new customers despite the initial loss they suffer due to the handset subsidy, as revenue is apportioned across the length of the contract. Such accounting practices are widely used by operators worldwide and are set out within the existing accounting guidelines.
 
However, this could soon change.
 
The two main global accounting bodies are working to finalize a new revenue-recognition standard that is to set new rules about how to account for and report on contracts with customers. Compared with the existing policy, which sees a bundled sale as a single customer contract, these new rules split a customer contract into two separate components: selling handsets and providing telecom services.
 
 
The new policy will essentially unbundle the contract and consider the price of a handset and the price of telecom services on a stand-alone basis, which would increase handset revenue and decrease service revenue. It will also give operators an incentive to recognize revenue from a typical telecom bundled sale earlier than the current approach, affecting EBITDA.
 
The graphic below illustrates the revenue recognition under both the existing and the new accounting standards. It is based on a two-year mobile services contract with a service plan of $30 a month and a handset, which would otherwise be sold for $500, subsidized at $200. As the figure shows, the new standard does not have an impact on the total revenue from a customer contract but it significantly changes the revenue allocation between handset and service revenue.
 
 
Fig: Comparison of the revenue treatment under the existing and the new standard
 
The new standard suggests that, at the moment, handset revenue is deflated and service revenue is inflated by the handset component.
 
This is a key argument, especially in case of the highly-subsidized and hence loss-making smartphones. We have looked at some of the current pay-monthly plans in the UK to estimate the impact that the new accounting standard may have on service revenue. We selected O2 UK pay-monthly plans on top-market Samsung and Apple devices that were spread over 24 months and included unlimited minutes, unlimited texts, 1GB of data allowance and a subsidized device. We then compared these plans with SIM-only plans to estimate the proportion of handset revenue that is included in the service revenue. We calculated that, based on these plans linked with top-market subsidized smartphones, 35% of service revenue is in fact revenue from subsidized devices.
 
In other words, based on the selected pay-monthly plan mix, 35% of service revenue does not relate to telecom services. Under the new revenue-recognition standard, this proportion will need to be removed from service revenue and allocated to handset revenue.
 
Furthermore, this proportion is affected by the level of the subsidy and the length of the contract. The higher the subsidy level and the longer the contract, the more inflated the service revenue currently is and the bigger the impact that the new revenue policy will have on it.
 
However, the real impact of the new standard on operator service revenue will depend on the plan mix applied by each operator. The new standard may cause changes to operator behavior as they attempt to align their pricing strategies with their accounting and financial reporting.
 
In fact, operators have begun to make changes to the way they offer handsets to the mass market as they look for more profitable product mix. Apart from a standard pay-monthly plan with a subsidized handset, consumers are offered SIM-only plans and new handset-financing schemes, which have a logic that aligns with the new accounting standard. An example is the newly-launched O2 Refresh plan that gives customers the choice between a handset purchased upfront or in instalments over the course of 24 months – customers can pay off the remaining value of the handset early and choose a different phone without affecting their airtime plan or early termination fee.
 
 
We will be looking into the financial aspects of handset financing in more detail so watch this space. In the meantime, you can check out the following report
 
The new revenue-recognition standard, which is expected to be finalized by July 2013 and effective by January 2017, does raise many other questions. In particular, the carriers claim that the new standard will give an advantage to sales through an indirect channel. The standard also introduces estimates of stand-alone prices for telecoms services and handsets if they are not freely available.
 
Furthermore, the new treatment of revenue and related cost will bring more volatility in the income statement, affecting KPIs such as revenue and EBITDA. We have dealt with this topic in more depth in this analysis piece.
 
*This is a simplified version of total revenue formulae. Typically, total revenue also includes “other revenue” related to activity not directly associated with the core business proposition of a company.
 
Milena Konecna, CFA is a financial analyst at Informa Telecoms and Media. For more information, visit www.informatandm.com/

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