In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) for public business entities, certain not-for-profit entities, and certain employee benefit plans. It becomes effective for public entities for annual reporting periods beginning after December 15, 2017. In addition to changing things dramatically in the accounting and financial realms, this new revenue recognition standard which may significantly impact the compliance profession, compliance programs and compliance practitioners going forward. In this episode, we consider how the new revenue recognition standard could shake up the software industry.
Matt Kelly and I have put together a five-part podcast series where we explore implications of this new revenue recognition standard. Each podcast is short, 11-13 minutes and deals with one topic on the new revenue recognition standard. The schedule for this week is:
Part 3: Shaking up software revenue recognition.
Part 4: Auditors need to pay attention.
Part 5: What does it all mean for compliance (and everyone else)?
One of the industries which may greatly feel the impact of the new revenue recognition standards is the software industry. Kelly noted, the new revenue recognition rule will ultimately allow some portion of the software sector to recognize more of their long-term contract revenue immediately. He believes they initially may think something along the lines of “Hey that’s sounds good right. We can hit our quarterly numbers. However, that then brings about bigger strategic questions.” So the reality may be somewhat different as a software company might need to think about this might well drive much more volatile revenue patterns over a multi-year period.
Kelly provide an example of the volatility from one of the companies he has studied, Microsoft. He stated that “when Microsoft adopted the revenue recognition standard earlier this summer, it actually pushed its revenues up because all those liabilities that would have been deferred revenue on the balance sheet recognized them all at once. Microsoft’s total revenue for 2017 went from $8.9bn to $26.5bn.” All that just because of a change in revenue recognition.
He then gave a more tangible example of a specific contract, where a company entered into a contract for five years, paying $500,000 and receiving 1000 seat licenses and four years of updates. Under the prior revenue recognition standards, the software company recognized a $100,000 in that first year when they signed the deal and then they had $400,000 of deferred revenue, which they recognized in chunks of $100,000 per year. Now a software company under the same scenario could recognized the entire $500,000 in the first year. While this may look great, it has serious implications. First and foremost, it will impact the software company’s balance sheet for the final four years of the five-year contract. It will seem most bare, with no deferred revenue. Kelly concluded “that’s the sort of thing that the software companies sector is going to go through a bit of a blender in early 2018 as people start to realize what all this means.”
Another obvious area of change will be in commission payments for sales persons and third parties. Previously they may have been paid when the revenue was recognized over the life of a contract. Now it may be all up front in the first year. This could cause a commission payment to be made in Year 1 of a 5-year contract. This would present the same cash flow issue for a sales person. Now consider this in a FCPA context. The five-year split of a commission payment has acted as an internal compliance control to keep such payments low enough so as not to create a fund for bribery. Now that type of internal control may not be available to the Chief Compliance Officer.
In a white paper for CalcBench, Kelly and Pranav Ghai found several themes emerging for software companies under the new revenue recognition standard.
First, software companies expect the new standard to accelerate revenue recognition for some long-term software contracts, where previously the revenue would have been recognized in increments across the life of the contract. This is because the new standard eliminates the need for “vendor-specific objective evidence” (VSOE). With the VSOE requirement gone, the new standard will allow firms to recognize more of the revenue from a long-term contract immediately.
Second, numerous firms said the new standard will change how they account for sales commissions, which qualify as costs of obtaining contracts. Under the new standard, sales commissions can be capitalized over the term of a contract, rather than expensed immediately. That means deferred commissions will increase as an asset on the balance sheet, and the amortization costs will be expensed over the term of the contract.
Finally, the data does raise questions about how well-prepared some software firms are for the new standard. While numerous firms say they plan to implement the standard by Jan. 1, 2018— but still report that they are uncertain about its possible effect, or even what adoption method they will use.
Perhaps one of the most unintended consequences will be for software companies looking for some sort of a merger, exit or those looking for an investment round from private equity or venture capital. The difficulty for PE or VC will be to determine what a software company’s value might be over a period of time. This may end up being one of the most critical questions facing software companies and those who invest in them.
I hope you will continue to join us for our exploration this week. Tomorrow in Part IV, we will consider how and why auditors need to pay attention.