New Accounting Standard Changing Software & Telecom Industries
By Brent Miller, CFA
President & COO, Gradient Analytics (a Sabrient Systems company)
“Change is the law of life. And those who look only to the past or present are certain to miss the future.” – JFK
When evaluating the earnings quality of a given company, a forensic accounting firm like Gradient Analytics focuses on key indicators that may indicate that a company has taken liberties to cosmetically enhance its financial performance via aggressive revenue recognition and/or the understatement of expenses. Signals that a firm may be engaging in financial gamesmanship include:
- Divergence between reported earnings and free cash flow (i.e., an increase in accruals)
- Overstatement of assets
- Understatement of liabilities
- Negative or decelerating organic revenue growth
- Persistently widening gap between GAAP and non-GAAP EPS
In this article, I discuss a new amendment to the accounting standards that seeks to reduce inconsistencies and improve standardization of revenue recognition practices. Read more...
When most market participants hear about a new accounting standard, there is a general tendency to deemphasize its significance as most rule changes do not have a major impact on business-as-usual. While this assumption may be true in most cases, it also likely suggests a reluctance to read the source material and fully explore the ramifications on the firm’s financial statement.
After all, reading and interpreting pronouncements from an accounting standard authority is not the most exciting endeavor (at least for most of us). I would caution that ignoring or failing to fully comprehend the ramifications of sweeping changes to existing accounting standards puts one at a considerable disadvantage in the market.
ASC 606 represents an example of one of these far-reaching shifts that could potentially impact a significant number of publicly-traded companies in the U.S. across a broad spectrum of industries.
In the discussion that follows, I will attempt to summarize ASC 606, discuss its most important implications, identify companies that are likely to be materially affected, and discuss the possible financial statement impact of the new standard on these firms. This article is not meant to be an exhaustive study of ASC 606 but rather a summary highlighting the most critical implications of this new standard.
What is ASC 606?
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, which will amend FASB Accounting Codification by creating Topic 606 (ASC 606). The FASB subsequently issued several amendments to ASU No. 2014-09 to provide clarification on the guidance. ASC 606 was aimed at reducing or eliminating inconsistencies in revenue recognition standards both across industries and between U.S. GAAP and International Financial Reporting Standards (IFRS).
Public companies reporting financial results under U.S. GAAP must adopt ASC 606 for reporting periods beginning after 12/15/17, which equates to 01/01/18 for companies reporting results on a calendar basis. Early adoption is permitted for periods beginning after 12/15/16.
ASC 606 revenue recognition standard will apply to all firms that: (1) enter into contracts to transfer goods or services, (2) or enter into contracts for the transfer of nonfinancial assets unless those contracts fall within the scope of other standards. In order to adhere to the core principles of ASC 606, companies must take the following actions as part of their revenue recognition policies:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue when or as the entity satisfies a performance obligation
Who will be Most Affected?
While the new standard will impact a wide variety of firms across a wide-ranging array of industries, Gradient believes that companies in the software space will be most acutely affected by the change, particularly those firms that report software licensing revenue under multiple deliverable arrangements that include post-contract customer support (PCS, i.e. phone support, bug fixes, maintenance).
Under old guidelines, there was no distinction between the various types of maintenance and support activities that software companies provide to customers. All technical support and software enhancements were lumped into a single accounting unit (PCS). Using this guidance, in order to separately allocate software licensing revenue and the various components of PCS revenue in a bundled software arrangement, Vendor Specific Objective Evidence (VSOE) of the selling prices of the various components was required.
Under the new standard, the unit of account for revenue recognition is a performance obligation (see step 2 of the five-stage revenue recognition process noted previously), which the standard defines as “a promise in a contract with a customer to transfer a good or service to that customer.”
Performance obligations can be accounted for separately if they are distinct. A good or service is distinct if (1) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer, and (2) each good or service within the contract is distinct from one another within the context of the contract. While the first item is fairly intuitive, a good rule of thumb for understanding the second characteristic would be if one were to remove the good or service from the contract, would the remaining goods or services be materially affected? If the answer to this question is no, then the good or service removed has a greater likelihood of being considered distinct under the new standard.
What are the Implications for Revenue Recognition?
The ability to segment bundled software product offerings into distinct performance obligations has two material implications.
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Under the prior standard, for bundled software arrangements that contain specified upgrade rights to customers, firms were required to defer all revenue until the upgraded software features were delivered to the customer under the prior standard. For example, if a company delivers version 1.0 of a software product to a customer and agrees to develop additional features that will be included in a version 2.0 of the product, the company was required to fully defer all revenue associated with the arrangement until the upgraded features were delivered to the customer. ASC 606 allows for companies to recognize licensing revenue upon delivery of the initial software package (version 1.0 in the above example) rather than postpone revenue recognition until delivery of the promised software upgrades.
- VSOE is no longer a necessary condition to separately allocate revenue in bundled software arrangements. Once a transaction price has been allocated to the various performance obligations in the agreement, revenue can be recognized as an entity transfers control of the promised goods or services to the customer. Under the old standard, if VSOE of selling prices did not exist, the various components of the bundled software arrangement had to be recognized as a single unit and all revenue from the arrangement needed to be deferred. Cases where VSOE is difficult to establish include the following:
- Wide-ranging distribution of prices for PCS components. For example, if there are significant pricing outliers for PCS components, then VSOE can be challenging to establish.
- PCS bundled with a time-based software licenses, which convey the right to use the software for a fixed term. For example, VSOE cannot be established for time-based software licenses that have a duration of less than one year and are bundled with PCS that have a duration of less than one year. In addition, if the only undelivered element is PCS (as will be the case in most time-based software license/PCS bundles), the entire transaction price was required to be recognized ratably over the support period. As a result of these issues, a higher proportion of time-based software licensing revenue is recognized ratably by most firms under the prior standard.
Consequently, firms that derive a material amount of revenue from software offerings with the above properties (software licenses with explicit upgrade rights, widely dispersed pricing for PCS, and time-based software licenses with bundled PCS) may now recognize a higher proportion of the associated software licensing revenue on an upfront, rather than ratable basis.
How will ASC 606 Impact Financial Statements?
Companies have two choices when applying ASC 606:
- Full retrospective adoption in which revenue and other impacts of the change in accounting principle will need to be restated for the most recent two fiscal years (e.g. 2016 and 2017 for companies adopting the standard for 2017).
- Adoption on a modified retrospective basis. Companies that opt for the modified retrospective adoption will recognize the cumulative impact of applying the new standard to existing (i.e. in process) contracts in the opening balance of retained earnings on the balance sheet. This cumulative catch-up adjustment represents the revenue and expenses that would have been recognized on existing contracts in prior periods under the new standard.
Regardless of the chosen method, for technology companies most affected by the change—firms with a significant amount of time-based software licenses bundled with PCS—the top-line impact will be somewhat nebulous in the initial period of adoption.
For example, if the “new” upfront revenue that previously would have been deferred exceeds the “lost” revenue from in-process contracts (which is now recognized in prior periods or in retained earnings), revenue may be higher in the adoption year under the new standard versus the prior guidance. The opposite is also true.
The balance sheet impact is clearer. We would expect to see a relative decline in deferred revenue on a going forward basis as these companies shift from a ratable to upfront revenue recognition for a larger percentage of their software licensing contracts. We would not expect operating cash flow to be materially affected as the timing of the underlying cash flows have not changed, only the timing of revenue and expense recognition. To put it another way, deferred revenue is not declining because the affected companies are collecting less cash from their customers.
Other Important Considerations
While we will not go into great detail regarding these additional considerations as they are beyond the scope of this examination, we believe they have material implications for revenue and expense recognition practices and wanted to provide a brief explanation of each.
First, firms that previously deferred recognition of some or all indirect revenue until sell-through by resellers/distributors may now recognize a portion of the revenue on a sell-in basis. Under the new standard, a firm may recognize the portion of the revenue on sale to distributors that is not likely (or "probable") to be returned or reversed in the future. In order to do so, the sale to the distributor must not be consignment-based, meaning that the control over the product has been transferred to the reseller.
In short, firms operating in a wide array of industries that: (i) rely on sales to distributors/resellers for a material portion of their revenue, or (ii) have historically deferred revenue recognition until sell-through by the distributor and reseller, may be able to recognize a higher proportion of this revenue on a sell-in basis under the new standard.
Second, in addition to these sweeping changes to revenue recognition practices, the new standard may also affect the operating margin profiles of certain companies as it requires incremental contract acquisition and fulfillment costs to be capitalized. Examples of contract acquisition costs include sales commissions, fees paid to third parties, and provisioning activities.
The amortization period for the amortization of these costs must be consistent with the pattern of when the related goods and services are provided to the customer. Costs can be expensed as incurred only if the amortization period is less than one year.
While this guidance has implications for firms in a broad range of industries, Gradient believes that companies in the Telecommunications sector will be most impacted by this change as the new standard requires a greater capitalization of costs than is typical within the sector. As a result, recognizing contract acquisition and fulfillment costs over time would have the effect of boosting operating margin performance for companies with material contract acquisition costs.
Summary
While ASC 606 will affect revenue recognition practices across a broad swath of industries, Gradient believes that firms in the software industry will be most materially impacted by the change. In particular, those companies that bundle software licenses (and time-based licenses in particular) with PCS may be able to recognize a much higher percentage of software license revenue on an upfront basis under the new standard. In addition, companies that sell software licenses with upgrade rights may no longer have to postpone recognition of the initial software revenue until the release of the upgrades.
The top-line impact in the period of adoption depends on whether the upfront recognition of new software licensing revenue exceeds the lost revenue from previously deferred software licensing revenue. On the balance sheet, we would expect to see deferred revenue decline relative to sales as these companies defer less software licensing revenue. Operating cash flow performance should be largely unaffected.
While not confined to the software space, two additional ASC 606 considerations have material implications for revenue and expense recognition in our view. First, companies that record revenue on sales to distributors upon sell-through to the end customer may be able to record a higher proportion of revenue on a sell-in basis (when the good is transferred to the distributor/reseller) under the new standard.
Finally, Gradient believes that companies in the Telecommunications sector will be most affected by the new standard’s endorsement of the amortization of contract acquisition/fulfillment costs. This change could boost operating margin performance of companies within the sector that were previously expensing these costs as incurred.
Disclosure: The author has no positions in stocks or ETFs mentioned.
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