Financial Analysis Implications of New Revenue Recipe
The revised revenue recognition requirements (Accounting Standard Update- Topic 606) become effective from the beginning of 2018 and they represent an important change for investors, particularly as revenue is integral for financial analysis across all businesses.
Stock market reactions to any news of possible revenue misreporting (e.g., Valeant, IBM, Boeing, Tesco, Toshiba, Enron) drives home the importance that investors attach to revenue as a performance measure, valuation input, and as an indicator of management quality and integrity. Investor-relevant improvements from the revised requirements include increased comparable global reporting as there will be relatively converged requirements between IFRS and US GAAP; and improved disclosures.
An odd feature of current reporting is that although revenue is arguably the most important financial statement line item, related disclosures (including within the segment reporting sections) are usually bare-bone, boilerplate and inconsistent across companies. In turn, the lack of robust revenue disclosures as well as the complex, ever evolving nature of customer contracts across business models makes it difficult for investors to forecast the revenue changes that will likely result from the revised requirements. Not to mention that many companies are yet to disclose the anticipated effects of the new standard.
Hence, there is an urgency for investors to engage with company management and to probe on the implications of the revised requirements towards the amount and timing of revenue; as well as to ascertain the corresponding impact on gross margin profiles. Below is an elaboration on different financial analysis aspects.
Track Changes in Revenue Patterns
The software industry provides a perfect example of how various aspects of Topic 606 requirements can influence revenue patterns. An insightful elucidation of the practical implications of these revised requirements is accessible through a recently investor-targeted FASB webcast focused on the software industry, which highlights insights of two financial reporting experts from IBM and Microsoft.
The webcast outlines key differences in revenue patterns for Software as a Product versus Software as a Service (SaaS). The pricing structure of Software as a Product contracts includes upfront, point in time revenue due to software license installation fees and subsequent-period ratable (spread over time) revenue due to license maintenance and upgrade fees.
In contrast, the SaaS business model (e.g. Salesforce, Workday) has mainly ratable revenue patterns. Topic 606 has multiple requirements that can impact on the amount and timing of revenue including the application of significant judgment by management to determine and allocate a value to distinct performance obligations.
For example, it allows the use of estimated selling prices when actual transaction prices of unfulfilled promises to customer or performance obligations (e.g. software upgrades) are still undetermined. This is a departure from the more conservative requirements to apply vendor-specific objective evidence (VSOE) prior to allocating revenue amounts to future deliverables.
The FASB webcast highlighted that in the software industry changes in revenue patterns could mainly arise for hybrid business models (i.e. a combination of traditional software as a product and SaaS).
Do Not Overlook Gross Margins Effects
It is important for investors to be alert to cost recognition impacts arising from Topic 606’s additional cost recognition guidance and to correspondingly monitor how the economics of businesses are getting reflected by the combination of revenue and cost recognition. Under Topic 606, costs of obtaining and fulfilling customer contracts will be capitalized and subsequently amortized or impaired over the expected life of the contract.
The incremental capitalization of costs (e.g. sales commissions in software industry as highlighted by the FASB webcast speakers) and their subsequent amortization or impairment could result in greater matching in the recognition of contract costs and contract revenues. In turn, this could lead to smoother period-to-period margins. For example, high-growth SaaS providers that have tended to portray a loss-making pattern in the first few years could portray smoother margins over the contract term.
Keep Sight on the Economics of Businesses
Beyond the issues flagged above in discussing the software industry revenue patterns, there are many other customer contract features (e.g. contract definition, uncertain future amounts to be received from customer, unexercised customer rights, financing arrangements, evidence of transfer of control to customer) that could affect the amount, timing and uncertainty of revenue for different businesses. Changes could occur in aerospace, engineering, construction, contract manufacturers, real estate, telecommunication, healthcare, variety of manufacturers, retailers, e-commerce firms, asset management firms, and other intellectual property intensive firms.
Nevertheless, investors should remember that the intrinsic value of companies is primarily driven by real economics of businesses rather than by accounting changes. They should always distinguish between changes in reported revenue patterns arising due to:
a.) Purely the effects of changes in companies’ accounting judgments on existing customer contracts and concomitant impacts on periodic revenue patterns;
b.) Changes in customer contracts including pricing changes and/or an alteration of the customer value proposition such as when software companies shift from a product to subscription business model; and
c.) Changes in customer demand influenced by seasonality, economic cycle, shifts in customer tastes, and product obsolescence.
Only B and C types of changes really affect the economic value of companies. In addition, investors should keep track of real economic value creation of companies by continuing to monitor the cash conversion of revenue as well as the correlation between revenue, gross margins and the cash flow from operations.
Monitor Transition Reporting and Disclosures
Transition reporting can help investors to discern the effects of revised standard and potentially allow a like for like comparison for a few years of revenue numbers based on the new model. Preparers can choose between providing full retrospective transition (i.e., 2018, 2017 and 2016), modified retrospective transition with practical expedients, and cumulative catch-up transition (2018 onwards, a cumulative catch-up in opening equity and disclosure of what current year revenue would have been under the old guidance). The ideal approach for investors would be the full retrospective method but indications are that most companies are going to apply the modified retrospective.
This could also present a challenge towards comparing multi-year revenue trend data across companies as different entities may select different practical expedients.
Discern Revenue Risk, Key Judgments and Future Revenue Through Disclosures
The revised requirements have updated disclosures including significant judgments; revenue disaggregation; changes in contract assets and contract liabilities; and performance obligations (>1 year). These disclosures should help investors to discern revenue-related company specific judgments alongside any underlying associated uncertainty. Investors should also be aware that disclosed performance obligations will likely be a subset of future revenue. As such, investors will still have to rely on order backlog information reported within the MD&A as well as the profile of contract liabilities (equivalent to current deferred revenue).
In summary, the revised accounting changes will require ongoing due diligence by investors so as to appropriately interpret reported revenues.
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Vincent Papa, Interim Head Financial Reporting Policy at the CFA Institute has approximately 10 years’ experience in developing financial reporting policy for capital markets. He is currently based in CFA Institute’s Brussels office.