ASC 606 or 666? Revenue recognition standard could spell trouble for software companies
The revenue recognition standard that takes effect in December for public companies could pose challenges for technology businesses, particularly those relying on traditional subscription licenses, and many companies aren’t ready for the impact on their financials.
“Revenue recognition feels like a big, big issue,” said Zuora CEO Tien Tzuo, whose company specializes in software for managing subscriptions. “This feels as big or bigger than Y2K or SOX. SOX was a big heavy cost, but it wasn’t like you were in danger of missing your earnings call, or you had to report earnings that differed from expectations, not because anything changed in your business but because of accounting standards. We should be a little worried. There’s a surprise looming when earnings season kicks off at the start of next year and I don’t think we’re ready for it.”
He believes the Financial Accounting Standards Board isn’t taking into account the changing software industry, which is moving increasingly to the cloud, in the revenue recognition standard, also known as ASC 606.
“More and more of the real information is flowing out of the GAAP financials and into either footnotes or non-GAAP financials,” said Tzuo during an interview at Zuora's Subscribed conference in New York last week. “You’re back to the world where it’s harder to compare apples to apples, one financial statement to another. Instead of actually creating the rules, [FASB] seems to have gone the other way. They seem to say, look, we’re going to have this concept called deliverability of the contract. Did you deliver on what you contracted for? But we’re not going to define it. We’re going to let every company define it, and they’re just going to have to disclose how they do it with sufficient information in their filings. And that’s not really good. So we’re actually creating more ambiguity. We’re putting more judgment back into the hands of the CFO and CEO, so we actually think in talking to companies that these new ASC 606 rules are going to be a big step back. I think the intention is right, but the actual implementation has been a bit off base.”
The revenue recognition standard is also referred to as ASC 606, short for Topic 606 in the Accounting Standards Codification. But Tzuo suggested it might get more attention from companies if it had a catchier name.
“When we say things like ASC 606, the problem is you just don’t have an Enron, a Y2K,” he said. “ASC 606? I don’t know what you’re saying. We’ve got to give this thing a sexier name. It should be called ASC 666.”
Christoph Hütten, chief accounting officer at SAP, helped the International Accounting Standards Board develop its version of the revenue recognition standard under International Financial Reporting Standards, IFRS 15, which is mostly converged with ASC 606. “I think it’s more of a management, if not a cultural, change than an accounting change,” he said. “In SAP and a lot of our peers, revenue recognition in a lot of scenarios is a gatekeeper for good business. Everyone in sales and other functions look at revenue because they know that’s driving their compensation and commissions. That’s why they try to structure deals in a way that they are favorable from a revenue recognition perspective. And a lot of them have quite some expertise meanwhile in revenue recognition. Lots of companies tend to have structures of revenue recognition experts in the back who support them.”
He pointed out that SAP has separate accounting and revenue recognition guidelines. “Our accounting guideline covering everything beyond revenue recognition is about 500 to 600 pages,” said Hütten. “Our revenue recognition guideline is 700 pages. So the topic of revenue alone covers more pages in our guide than all other topics in accounting together. That’s to give you an idea of how important revenue recognition is for the company. And now somehow the rules of the game change. They’ve changed in a way that we have certain transactions that may have been unfavorable from a revenue recognition [standpoint] in the past that suddenly now get favorable revenue treatment. For some of those, people applaud—‘in a way we always wanted to do that and now finally we can and it’s great for the company.’ For some others you may think, well, we were happy in the past that we had revenue recognition as a gatekeeper. That helped prevent such business practices. Now revenue recognition moves out of the gatekeeper role, and now the question is what do we do with that vacancy? How do we fill this gatekeeper through something other than the revenue recognition rules?”
Zuora’s Tzuo believes many companies are unprepared for the changes that will be necessary. “A lot of companies were blindsided by this,” said Tzuo. “I think this has really caught them by surprise. It just doesn’t look like FASB spent a lot of time listening, especially to what I would say the growth sectors are in our economy, which is tech. It feels like a lot of these rules are based on old-school construction service contracts where they’re paying me over a three-year period to build a gigantic building or a retail complex, and it’s not based on this new world of services. There are services we can tap into on our phones and that we can pay for on an ongoing basis.”
With the revenue recognition standard, FASB and the IASB aimed to eliminate much of the industry-specific guidance that existed under the old accounting standards, making it more principles-based as opposed to rules-based. They consulted extensively with companies and stakeholders in a variety of industries while developing the standard, and addressed implementation issues through a joint Transition Resource Group.
“I think the goal is good, based on the fact that more and more of our economy is not shipping products, referring to the fact that we want some rules that can transcend industries versus something that’s too complex, with different rules for different industries, recognizing that we want some kind of harmonization between U.S. and European laws,” said Tzuo. “All of that is really, really good, but I think when you look at the implementation, there’s just a lot of silly things. There’s an arbitrary thing about commissions being over five years. Why five years? There are things too about selling a term license on a piece of software. If it was a three-year contract, I used to have to recognize the revenue over three years. The industry finally moved to some level of standardization, and now the rules say you’ve got to recognize the whole thing upfront. We’re back into that world that we tried to move away from. If you sell a five-year contract and I sell a three-year contract, it’s the same product, and the customers are paying on an annual basis, so why should you recognize more revenue than me? It’s going to encourage you to go and do longer-term contracts at a bigger discount, so you book more revenue this quarter, but you’re really just sacrificing your future revenue. All these things we tried to get away from, and it’s only going to slide back.”
At SAP, Hütten believes that revenue recognition for software subscriptions will differ somewhat for various types of products. “I think it depends a little bit on what you’re selling to the customer,” he said. “I think if it is a clear pure cloud subscription, and truly a cloud subscription, where the customer doesn’t install the software on the customer’s server, but it’s installed on the vendor’s server and the customer only accesses it, it’s really a service. For those, I don’t see significant changes over the plain vanilla where the customer pays a fixed fee for a certain period and gets the right to access. The challenge is more in the area where people sell either on-premise subscriptions or hybrid subscriptions, so the customer still installs the software, but rather than in the past buying the software once for a perpetual license one-time fee, it’s now a recurring fee. There are a number of software companies who have moved from that old model of a one-time purchase to this subscription model. With these licenses, even if the customer pays on a subscription basis, revenue will be recognized upfront under certain criteria. You will see companies that have moved over from a one-time event revenue recognition, one-sale software license revenue model over the last few years and moved into a subscription model and got applause for it from the capital markets. They now are challenged they’ll be pulled back into our old world of recognizing revenue upfront again for the entire contract fee because it is in the end not a cloud subscription, but a term license, and term licenses are now recognized upfront where they were under certain circumstances recognized over time.”
That could be a challenge for investors and capital markets, according to Hütten. “You can imagine if a company that has just walked through that change, going from upfront recognition to a range of recognition and got applause from the capital markets, to now go back to the capital markets and say, ‘Sorry, I’m back where I was. The business model hasn’t changed. The customers still have subscriptions, but unfortunately the accounting pushes me back to recognizing them upfront.’ That will be a difficult story to sell. I don’t know whether it will affect their business, but at least it will be from an investor relations and capital markets perspective a difficult story to tell. It’s not really a challenge for us because we’ve never been heavily in this term license business. I know some other companies who do, but it’s not for us. But I know it is for a number of other software companies.”
He believes software companies are ahead of the curve, however, compared to many other industries. “I’m seeing a lot of companies I personally would say are not well prepared and have started implementation projects too late and they struggle, not so much in our industry, and I think that is because revenue recognition is so important,” said Hütten. “Everyone has an eye on the changes coming. Everyone knows it won’t be a simple one. I haven’t seen a lot of software companies that I think are late. In other industries I see it a lot, and that’s really where people thought it can’t mean a lot for them, and suddenly understand that it means much more than they expected.”
Many companies may use interim manual processes in the meantime until they are fully ready to embrace the new standard with more automated processes, he predicts.
“One of the biggest challenges is to get the attention, support and engagement of functions other than finance,” said Hütten. “Most people outside finance think that accounting is very boring. They’re completely wrong, but unfortunately they’ve got this misconception, and that is a challenge to get them engaged and make them understand this is not only an accounting change. Then you need to look deeply into your processes and focus on both compliance and being efficient in compliance. For companies that are heavily affected, I don’t see how you could do it manually. If you’ve got complex contracts, you need to have technology to support you in what you are doing. Automation is key, and people shouldn’t underestimate the efforts they will need to go through if they want to do the stuff manually. I think that’s the most important piece of it.”
Public companies won’t have any choice but to adopt the new standard by early next year, though. “I think it is what it is for now,” said Tzuo. “Companies are going to rush to adopt it. There’s too much interpretation, too much judgment. Most companies will be OK, but I think there will be some high-profile disasters where there will be some misunderstanding or somebody will miss or delay their release of earnings and the stock prices are going to drop. Hopefully a year or two from now, we’ll normalize it to a different place and we’ll start advancing the ball again.”