Study: Revenue Recognition Standard Could Lead to Volatility in Software Industry

By:
Chris Gaetano
Published Date:
Aug 23, 2017
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A recent study has found that revenue recognition practices particular to the software industry could lead to earnings volatility once the new standards go into effect. The FASB revenue recognition standard, developed as a major component of the FASB and IASB's convergence project, replaces the myriad industry-specific guidance currently in U.S. GAAP with a unitary model based on the identification and fulfillment of "performance obligations" in customer contracts. The study—conducted by Radical Compliance (a news publication about corporate governance issues) and Calcbench (a financial data research firm)—said that the new standard could hold material impacts on certain software companies due to the timing of their current revenue recognition methods. 

The study used Microsoft as an example. Right now, the company sells Windows 10 as a service, with automatic upgrades over time, which is recognized in increments across the lifetime of the contract with corporate customers. When Microsoft adopted the new standards early, though, it changed its method to recognize all Windows 10 revenue immediately at the time of sale and installation. This shift meant an adjustment of billions of dollars. The study said that financial analysts should be aware of the potential for similar changes at companies that used incremental revenue recognition models like Microsoft had done. 

"In many instances (such as Microsoft), the new revenue recognition standard will accelerate the recognition of deferred revenue, moving that number off the liabilities section of the balance sheet. That means firms with a higher ratio of deferred revenue
to current liabilities are more likely to experience disruption to the balance sheet," said the study's authors. 

While firms will be able to recognize revenues from contracts more quickly than before, the report said that earnings could be more volatile from one quarter to the next, depending on which large-dollar contracts are closed in any given quarter. So, if corporate customers in general tend to buy multi-year software contracts beginning Jan. 1, this means that  more software companies will be reporting stellar Q1 results every few years, followed by doldrums until the next big contract is signed. There will no longer be a steady pattern of moving revenue from the balance sheet, where it is locked away as deferred revenue, to the income statement. This means the amount of deferred revenues on the liabilities side of the balance sheet will decline, sometimes precipitously. 

"For companies such as those we have highlighted here, with significant deferred revenue, the decline could be substantial and swift. That could have follow-on consequences as management recalibrates the assets stockholder equity to account for the shift,"  said the paper. 

The study also noted that the new standard will affect how firms account for sales commissions, which quality as costs of obtaining contracts. Under the new standard, sales commissions can be capitalized over the term of the contract rather than expensed immediately, which means that deferred commissions will increase as an asset on the balance sheets, with the amortization costs then expensed over the terms of the contract. 

The study also went to look at companies that are listed as peers of Microsoft, then looked at which ones, like Microsoft prior to switching, are unusually dependent on future revenues locked away on the liabilities section of the balance sheet. This created a population of 82 companies with a deferred revenue/current liability ratio of 50 percent or more, 11 of which had a ratio above 100 percent. Of these 11 companies, though, the study noted that only one said the new standards will have a material effect on its financial statements, and only one said there will not be any material effect. Another said nothing at all. The remainder said they were still evaluating the issue. 

The authors said the data raises questions about how well-prepared some software firms are for the new standard. With the effective date less than four months away, numerous firms are still uncertain as to the effects or even what adoption method they will use. 

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