New Revenue Recognition Standard (ASC 606) —Why Technology Companies Need to be Aware
Companies that attach services to their core products, professional services firms, and companies that sell their products as-a-service need to be aware of New Revenue Recognition Standard (ASC 606).
ASC 606, Revenue from Contracts with Customers
For privately held companies a new accounting standard will go into effect for fiscal years beginning after December 15, 2018 (i.e., fiscal year ending December 31, 2019); this standard took effect for public companies as of January 1, 2018. Its goal is a framework that allows greater comparability of revenue recognition methods across companies and industries and requires companies to show revenue in a way that represents how the company earns that revenue through providing services or transferring goods to customers.
It makes sense and sounds simple, but implementation could be complex; the standard applies on a contract-by-contract basis and targets technology companies in particular that tend to have multi-year contract terms. Furthermore, the standard is a principles-based standard, can require complex judgments and estimates to implement, and should not be seen as a simple standard to implement on day one.
The standard, ASC 606, Revenue from Contracts with Customers, outlines a core 5-step model. To be compliant with GAAP (Generally Accepted Accounting Principles), companies must:
- Identify all their customer contracts (including whether a contract actually exists).
- Define performance obligations in the contract.
- Indicate transaction price of the contract.
- Allocate the transaction price to the individual performance obligations.
- Recognize revenue as those obligations are satisfied.
For companies that attach services to their core products, professional services firms, and companies that sell their products as-a-service, this means that revenue must follow specific service delivery rather than being recognized in, for example, equal monthly installments. It also means that for multi-year contracts where the obligation may be final delivery, revenue may not be able to be recognized until the end of the contract.
Implementation of this standard could have far reaching effects. Timing of revenue reporting could change dramatically based on contract delivery terms. For this reason, there is “lookback” guidance to compare financials with prior periods. However, deferred revenue recognition may significantly impact revenue covenants in debt agreements and hinder applications for additional loans. Companies should discuss these issues with their bankers.
Deferred revenue recognition could also affect employee bonuses based on revenue targets even if cash payments have been made. On the operational side, companies need to review all contracts and note performance obligations. Financial systems must track this level of detail for revenue and expense recognition. Going forward, companies should keep these guidelines in mind when negotiating and structuring contracts with customers.
For the tech industry which has seen a high degree of Private Equity interest and M&A activity, due diligence will need to assess the impact of this standard on historical and future income statements. Although the new standard does not impact cash flows, changes in the timing of revenue recognition and increased earnings volatility may impact EBITDA and valuation models and the potential and amount of debt that can be secured. PE firm Partnership tax reporting on their investment portfolio will be affected as well.
To ensure tax compliance for your specific circumstances, consult your tax professional.
About the Author
Paula Goldstein, PhD, CPA, MBA, MS, Consulting CFO at Strategic Horizons, Inc., provide CFO and COO services and strategic, financial, and operational consulting. With a technology background and experience in manufacturing and distribution, most recently as CFO for an apparel manufacturer and retailer and experience running and turning around businesses, Ms. Goldstein has a track record helping companies grow profitably and streamline operations, partnering with business stakeholders to build and implement financial models and strategic and operational business plans.
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