More research, less noiz.
A Little More Information.
After 12 years in development, the FASB and IASB released Revenue from Contracts with Customers (ASC 606 andIFRS 15, commonly known as Topic 606), a nearlyall-encompassing, 5-step process towards recognizingrevenue. Also accompanying Topic 606 is a change toaccounting for contract costs (e.g. sales commissions),Other Assets and Deferred Costs: Contracts withCustomers(ASC 340-40), likely resulting in more costsdirectly related to contracts being capitalized. For UScompanies, the new standard replaces 100+ industry-specificrevenue guidance pieces, ideally (emphasis added) creatinggreater consistency across industries and betweencompanies. The standard goes into effect on January 1, 2018for calendar year-end companies.
The switch from a rules-based standard (Old GAAP) to aprinciples-based standard (Topic 606), brings a lot moremanagement judgement. Major judgement calls include theidentification of performance obligations (i.e. promisedstand-alone goods/services, separate sources of revenue)and allocating revenue based on the value of theperformance obligations (e.g. allocating the sales price ofWindows 10 to the software and the updates), which couldresult in a smoother/choppier top-line, as well as revenueaccelerating/decelerating (vs. Old GAAP). More judgementinvolves could result in the accounting better reflectingthe underlying economics of a contract, but also leavesmore room for manipulation.
Creating one revenue standard to rule them all ideally should increase comparability, but thatassumes management teams think alike (remember, thisstandard involves a lot of judgment). It remains to be seenwhether Topic 606 better reflects the underlying economicsof a transaction; we’ve seen encouraging examples ofcompanies no longer using non-GAAP metrics post-606adoption in the software space. Accompanying the numbersshould be disclosures that sufficiently describe thetransaction and judgment calls made, which have beensomewhat lackluster in the first year of adoption (of theones we’ve reviewed). Additionally, we’re hoping Topic 606will shine light on aggressive revenue recognition policiesand possibly bring additional enforcement measures ascompanies can no longer hide behind narrow accountingguidance of Old GAAP but will instead have to defend theirinterpretations of Topic 606’s principles.
A Few Items Worth Notin’.
- Topic 606 could cause revenue to be recognizedrevenue earlier or later, lumpier or smootherand impacts essentially all companies (to varyingdegrees).
- With Topic 606 comes new disclosureswhich should (emphasis added) help you assessmanagement’s judgement/estimates (we have not been tooimpressed so far).
- When reviewing your models,don’t forget about Topic 606-related “lost” or “found”revenue upon adoption, which is a biggie for companies adopting under themodified retrospective method (don’t restate prior resultsunder Topic 606, make a cumulative adjustment to retainedearnings on adoption date).
- Accounting for contract costs is changin’ too, which potentially brings smoother earnings and atemporary boost to margins.