Rev rec changes loom over US software houses

Revenue recognition challenge for software developers
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The move to global revenue recognition accounting principles is causing increasing anguish among US software companies who may see material impacts on their profits as a result.

The new international revenue recognition standard IFRS 15 ‘Revenue from Contracts with Customers’ will come into effect for annual reporting periods beginning on or after 1 January 2018, and will be accompanied in the USA by its own equivalent, ASC 606 which will apply to public companies for the next financial year starting after 15 December 2017.

The key requirement of the new standard is that businesses have to recognise revenue only when the obligations to which it applies have been fulfilled. To do this, preparers will need to go through the following five-step process to assess the correct treatments:

  1. Identify the contract(s)
  2. Identify the separate performance obligations
  3. Determine the transaction price
  4. Allocate the transaction price to the separate performance obligations
  5. Recognise revenue when the entity satisfies a performance obligation.

There have already been many complaints about the complexity of the new approach, but the standards-setters are able to shoot back that abuses in the past necessitated a more rigorous and realistic approach.

But analysts and CFOs in listed software companies are becoming increasingly aware that they are likely to see some material impacts on reported profits after implementing the new standard.

Software companies could see special challenges because many have signed long-term contracts with customers. Until the new standard, revenue from those contracts was recognised incrementally over the lifetime of the contract. But under the new revenue recognition standard, much of that money could be recognised immediately.

On the face of it, the new recognition principles should work in favour of “software as a service” providers because they are collecting regular sums from customers for facilities provided during the same financial period.

But subscription admin specialist Zuroa begged to differ. Its analysis highlighted troublespots for subscription-based companies because their contractual obligations can change quite frequently when customers upgrade or otherwise alter their contracts. Some changes might be handled as a modification to existing contracts, while others might create a new contract – requiring another financial reporting assessment.

The ongoing nature of subscription services which may include upfront fees and recurring elements also complicate decisions about whether to recognise revenue right away or defer it. Where prices are based on customer usage, another variable has to be assessed to determine the actual transaction price (step 3 in the rev rec process).

For example, if a sales team wants to introduce tiered pricing to encourage customers to pay for a certain number of users at a reduced rate, their finance team could start to get nervous about having to constantly monitor and adjust transaction prices on the fly.

 “For subscription-based companies, the new standards could impact growth by hindering sales and marketing efforts. In order to achieve compliance, businesses may feel forced to adjust their contract designs, pricing models, and practices for modifying and managing contracts. Companies might also feel obligated to change the way they forecast sales and manage their sales teams,” Zuora warned.

But the picture is even more complicated for “hybrid” software companies that sell a mixture of subscriptions and perpetual licences (think of some of the big, listed accounting developers such as Sage or Intuit).

Their contractual obligations can include telephone support, maintenance, product upgrades and implementation services and under the new standard they will need to allocate a proportion of the transaction price separately to each element, based on the price at which the company would sell the service or product independently. This is not that different from the allocations processes used under the existing standards, but a lot of guesswork will still be involved.

Financial analysis technology specialist Calcbench and the Radical Compliance blog recently published a paper looking at what the impacts of ASC 606 are likely to be on listed US software companies and identifying the companies most likely to experience significant changes in revenue patterns.

Microsoft provides a useful benchmark for the study, as the company adopted the new standard early when reporting its annual revenues on 2 August.

Microsoft has a lot of long-term contracts in place with corporate customers for Windows, and previously recognised that income across the life of the contract. Future revenue, for example from annual upgrades that haven’t happened yet were “bottled up on the balance sheet” as deferred revenues, as RadicalCompliance.com put it.

Numerous software firms are likely to experience more volatility in their revenue.

Under ASC 606, Microsoft was able to recognise that revenue immediately, with the result that it adjusted its 2016 revenues up by 6.8% to $91.2bn and its 2017 revenues up by 7.3% to $96.6bn. Other developers will not enjoy the same uplift, with 11 listed companies identified where the ratio of deferred revenue was more than 100% of current liabilities. The higher that ratio, the more dependent the developer is on long-term contracts and the more likely they are to experience material effects when implementing the new revenue standard.

“Numerous software firms are likely to experience more volatility in their revenue from one quarter to the next,” commented RadicalCompliance.com. “New volatility could affect sales executives’ compensation, and in turn affect your fraud risk.”

The study also looked at what companies were disclosing to investors about their approach to revenue recognition – as required by the new standard – and found that in many cases they said little or nothing about the implications of the impending standard.

Calcbench CEO Pranav Ghai commented: “This should set off alarm bells for at least some investors. We found lots of companies that could potentially see material changes in their revenue reporting - not definitely, but potentially - and yet they’ve disclosed very little to investors, even with the new standard taking effect only four months from now.”

About John Stokdyk

John Stokdyk is the global editor of AccountingWEB UK and AccountingWEB.com.

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