Five years after the Financial Accounting Standards Board (FASB) first issued new revenue recognition rules, we finally get to see its impact on reported financials. The new standard was originally scheduled to go into effect in 2016, but the FASB delayed implementation until 2018 due to concerns over the difficulty of implementation. As a result, the first 10-K’s utilizing the new standard came out earlier this year for most companies.
While the new standard, ASU 2014-09 (also referred to as ASC 606), primarily deals with revenue, it will also have significant impacts on how companies report expenses, as well as assets and liabilities on the balance sheet.
Most companies have seen relatively little impact from the new revenue recognition rules, but for a handful of industries it significantly distorted revenue and earnings over the past year. This report digs into how the new rule works, what’s changed, and how investors should respond.
How the New Rule Works
The FASB announced the new revenue recognition rule in 2014 as part of an effort to standardize accounting treatments and continue to converge U.S. Generally Accepted Accounting Principles (GAAP) with International Financial Reporting Standards (IFRS). As the FASB wrote in the announcement of the new rule:
“Previous revenue recognition guidance in U.S. GAAP comprised broad revenue recognition concepts together with numerous revenue requirements for particular industries or transactions, which sometimes resulted in different accounting for economically similar transactions.”
The new revenue recognition standard replaced the more than 100 different industry and transaction-specific guidelines with a basic, five-step framework. Under the new rule, companies must carry out the following steps:
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
In principle, these steps sound straightforward, but executing them is not always simple. The full standard runs 700 pages long with all the amendments included. These amendments give guidance on specific issues related to revenue recognition and outline the increased disclosure that will be required from companies under the new rules.
In addition to changing the way companies recognize revenue, the new rule impacts some of the expenses related to how companies obtain and satisfy contracts with customers. For example, companies now have more discretion to capitalize sales commissions for long-term contracts. Rather than being expensed immediately, these commissions are now recognized as contract assets on the balance sheet and amortized over the life of the contract.
All in all, the new standard was so complex that the FASB pushed back the implementation date to give companies more time to adjust. Fiscal year 2018 was the first year for which companies delivered fully audited financial statements under ASU 2014-09.
While every company that files under GAAP is subject to the new rule, the impact can vary widely. Some companies, like US Steel (X), saw no change to their financial statements. Others experienced significant boosts to revenue or earnings based on the new accounting rules. Below, we’ll walk through examples from three different industries that have been especially impacted.
Software: Verint Systems (VRNT)
We previously highlighted how ASU 2014-09 impacted Verint Systems’ (VRNT) 2018 earnings in our article, “This Tech Laggard Is Back in the Danger Zone.” The software industry has been particularly impacted by the new rule due to the long-term nature of many cloud software recurring revenue contracts.
Under previous guidelines, revenue from software licensing agreements where payment for the license is paid in installments over more than 12 months could only be recognized when the customer was billed for each payment. Under the new standards, contracted revenue can be recognized upon transfer of control of the software license.
This change accelerated the recognition of contracted revenue for software companies in 2018 and led to a significant increase in revenue for some companies. In fiscal year 2018, VRNT, for example, recognized additional revenues of $48 million (4% of total revenue and 50% of revenue growth) due to the adoption of the new standard, as shown in Figure 1.
Figure 1: VRNT Income Statement with and Without the New Revenue Recognition Rule
Sources: New Constructs, LLC and company filings
Figure 1 also shows that VRNT’s selling, general, and administrative expense declined by $14 million, primarily due to the capitalization of commissions paid to agents and sales personnel. As a result, VRNT received a $51.5 million boost to net income last year, which significantly impacted NOPAT as well. See Figure 2.
Figure 2: VRNT NOPAT With and Without Accounting Rule Change: 2013-TTM
Sources: New Constructs, LLC and company filings.
Normally, our Robo-Analyst technology would collect this information and make an adjustment to account for the impact of a new accounting rule change. However, ASU 2014-09 represents a complete overhaul of the revenue recognition process, and the disclosure around its impact is too inconsistent for us to fully disaggregate and adjust for its impact across all companies over all of their histories. Limited disclosures force us to accept this new standard as the default going forward and study disclosures on a case by case basis with the hope that we can find profit distortions.
Clearly, investors need to be on the lookout for companies – like Verint – with unusual changes to their income statement in 2018 based on this new rule. Because disclosures on how the companies apply the rule vary so much, we do not yet have comprehensive data on the rule’s impact. But, the rule has a material impact on every software company we’ve analyzed so far.
The good news for investors is that the distortionary effect of this rule should dissipate after a year. The revenue that was pulled forward into 2018 should be a one-time boost. The commissions that were capitalized appear on the income statement as amortization. VRNT, and other companies like it, should see their revenue growth and after-tax operating profit (NOPAT) revert to historical levels going forward.
This article originally published on September 18, 2019.
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