A set of new accounting rules that govern revenue recognition — said to be the biggest change in standards since the Sarbanes-Oxley Act of 2002 — will take effect next year, affecting either fiscal 2018 or 2019 for all U.S. companies.
The accounting changes are under the radar of many investors, who may scramble to make sense of what’s happening with the stocks, many of them blue chips like Microsoft, into which they’ve poured their money.
Under the designation of FASB 606 — FASB is an acronym for the Financial Accounting Standards Board — the new rules will make revenue recognition consistent across U.S. industries. It’s geared to help investors, but there could be near-term pain. Many companies will likely speed up revenue recognition and possibly make earnings more volatile from quarter to quarter.
“We expect that (the new rules) will cause significant investor confusion over the next 12 months to the financial analysis of companies ranging from small companies up to the largest, including Microsoft,” said a recent report from Citigroup.
But the rules aim to address a big problem.
Weak Link In Accounting
While top-line growth is a critical metric for investors, revenue recognition has been a weak link in accounting standards. With the new rules, Wall Street analysts and investors should get a better feel for how a company is doing and whether business is deteriorating or booming.
One goal is providing more transparency in sales backlogs, or revenue not yet recognized from contracts already signed. Some companies state backlogs, some don’t. Now they’ll have to put a number on it in many industries. Guidelines specific to the software and defense industries, for example, are going away.
In regulatory filings, companies also will be required to disclose more information on contracts. That should give investors and analysts more data on what risks or uncertainties companies face. Companies talk about things like pension costs in filings but don’t provide the same transparency on revenue issues.
Industries with the most “deferred revenue” — sales booked over time — will be most affected by FASB 606, says a Morgan Stanley report. Those include software, communications equipment, airlines, aerospace and defense.
In industries that will be impacted most by the new rules, some analysts are talking about using more steady free cash flow as an alternative metric to earnings per share. The reason is free cash flow will be less impacted by the 606 rules.
“I would expect to see more disclosures, certainly by the third quarter, on whether the standard is going to affect revenue recognition,” said Dusty Stallings, a partner at accounting giant PricewaterhouseCoopers.
Microsoft Is Early Adopter
Microsoft is expected to be one of the prominent early adopters of the new standard. It reports its 2017 fiscal fourth-quarter earnings on July 20, and a few weeks later the company plans to restate earnings for the prior two years.
Also on the list with Microsoft are a number of other Dow components, including General Electric (GE), Boeing (BA) and Verizon Communications (VZ).
A wide swath of other firms in many industries are expected to be impacted. They include Amazon.com (AMZN), American Airlines (AAL), AT&T (T), Electronic Arts (EA) and General Dynamics (GD). Others are First Solar (FLSR), Monsanto (MON) and T-Mobile US (TMUS)
Companies that recognize more revenue upfront could have more earnings volatility. Surprises to the upside may be followed by sudden, equally surprising shortfalls. Companies prefer that a total contract value be recognized over time, which provides more flexibility in smoothing out earnings to meet consensus estimates.
“New principle-based revenue rules will likely accelerate revenue recognition, while also introducing more volatility,” said Snehaja Mogre, a Morgan Stanley analyst in a report. “As the new standard will not impact actual cash flows, we expect investors to increase their reliance on cash flow metrics.”
Many companies are still studying the new FASB 606 rules, but crunch time is coming. Expectations run high that many companies will finally declare whether the 606 standard is “material” or not to financial results on June- or September-quarter earnings calls.
Impact On Windows 10
In Microsoft’s case, the new standard is expected to impact Windows 10 revenue in particular. Microsoft is expected to book Windows 10 revenue when it bills hardware makers rather than over the life of a PC or device using the software. Microsoft in May briefed financial analysts, telling them that in fiscal 2016 revenue would have been about 7% higher —$6 billion or so — had it used the new revenue standard back then.
While Microsoft will forecast earnings in July for its first fiscal quarter of 2018, it plans to update guidance in August using the new revenue recognition standard. When briefing analysts in May, Microsoft made the point that the FASB 606 rules will not impact free cash flow.
“Net-net, investors could start paying more attention to cash flows given increasing revenue variability,” Brent Bracelin, analyst at Pacific Crest Securities, said in a recent note to clients.
While some companies will opt to restate earnings for prior years, most are expected to take a “modified” compliance route, applying the new rules on a quarter-by-quarter basis going forward, adjusting results for new contracts, says Betsy Meter, an audit partner at KPMG.
“It’s industry-driven mainly,” she said. Companies that delay, though, will be less likely to take Microsoft’s approach and restate prior-year earnings, which gives investors more information.
“For industries where there is a significant impact, a full retrospective approach will give them some history and visibility,” Meter added.
Little Effect On Some
Some of the biggest names in tech, though, see little impact. Apple (AAPL), Facebook (FB) and Google-parent Alphabet (GOOGL) are among tech companies that expect little impact from the new standard. Chipmaker Intel (INTC) has not been heard from.
In general, the rules are expected to affect companies with multiyear contracts, licensing revenue and contracts that peg revenue to performance benchmarks. And they will also affect companies that use third-party sales distribution channels.
Revenue from Amazon-branded electronic devices sold through retailers will be booked earlier, rather than when consumers actually buy the devices, says a Connor Group report. The new rules also will impact Amazon gift cards, says the report.
Key to the new accounting rules is that revenue must often be booked right away and not stretched out over the term of contracts. AT&T, T-Mobile and Verizon will likely book more revenue from smartphone sales upfront, rather than over the course of an installment payment plan.
Salesforce.com (CRM) and Adobe (ADBE) are among software companies still studying the impact of 606 rules. Workday (WDAY) has decided to remove guidance for billings, a sales growth metric, as it adopts the new accounting rules. It’s unclear how many other companies may follow suit on billings.
Companies with cloud-based, software-as-a-servicer (SaaS) business models that involve renewable subscriptions are expected to be less impacted than those that sell software installed on a customer’s own in-house computers.
Only about 7% of SaaS provider ServiceNow’s (NOW) revenue comes from on-premise licenses, analysts say. Splunk (SPLK) and Ansys (ANSS), on the other hand, garner a large chunk of revenue from on-premise deals, says a William Blair report.
Staying Above It All
While Microsoft will likely book Windows 10 revenue sooner, its online Office 365 sales will be less affected. Cloud-based software is rented via the internet.
“SaaS models should see the least impact from the new standard, given that software is hosted and delivered over broadband connections vs. software installed on-premise,” said Bracelin.
Cisco Systems (CSCO), a big computer networking gear maker, could see its deferred revenue impacted, he says.
Many software companies may be in the process of renegotiating contracts to ease the impact of rule 606, says KPMG’s Meter.
Some software makers, such as Autodesk (ADSK), have already transitioned business models to subscription licenses for cloud software. Under the 606 rules, only software that is continuously updated is eligible for revenue recognition over time, or “ratably.”
A lot of U.S. companies had hoped for further delays in carrying out the 606 rules, which have been in the works for more than a decade.
“Companies know the time is upon them to get going,” said Stallings at PricewaterhouseCoopers. “There’s acceptance that this is going live on Jan. 1, 2018, for calendar-year companies.”