Revenue Recognition ‘Doomsday Clock’ Is Ticking

By Jayne Scuncio June 5, 2017

This article was originally published at CFO.com, written by Zuora CEO & Founder Tien Tzuo.

 

“Hopefully, fear is what you’re feeling now.” — Josh Paul, head of technical accounting and SEC reporting, Google

If you’re a subscription-based company or have any recurring revenue in your business, I have some good news and some bad news. Let’s start with the good: Congratulations. You have arrived. Your business model finally has some concrete accounting guidelines.

I’ve been banging the drum for years about how revenue recognition standards need to change to keep pace with the global explosion of digital services. Today’s accounting rules were written for the Spice Trade (literally — Luca Pacioli invented double-entry bookkeeping in the 15th century), and they simply don’t apply to the modern world of recurring digital services.

Well, apparently someone listened — not just to me, but to almost everyone in the rapidly growing Subscription Economy. Accounting changes indeed are coming, and very soon. Compliance deadlines for the new ASC 606 and IFRS 15 revenue recognition rules are just around the corner, starting with fiscal years that begin after Dec. 15, 2017, for public companies and a year later for private ones.

This is arguably one of the biggest compliance changes for business since Sarbanes-Oxley. Bloomberg reports that “public companies — including Amazon.com and Microsoft — are gearing up for the most historic accounting changes to hit U.S. capital markets in decades.” Denis Pombriant of Beagle Research writes, “We have before us a perfect accounting storm, the likes of which has not been seen since the late 1990s.”

Yes, this is like Y2K, except this time you should believe the hype. It all goes down in six months.

So what’s going on, exactly?

In 2014, the Federal Accounting Standards Board and its European counterpart, the International Accounting Standards Board, issued new standards for recognizing revenue from contracts with customers. The goal was to simplify and harmonize revenue recognition practices.

Given three years to do something about it, most finance departments did nothing. And with a few exceptions, today they’re either panicking to very little effect, or being willfully ignorant. Some corporate valuations are going to tank as a result.

Still, these are welcome changes. Right now the requirements for reporting recurring revenue — a critical metric for evaluating a company’s financial performance — vary across all sorts of different industries and markets.

These discrepancies create incongruent accounting results for economically similar transactions, rendering broad comparisons nearly impossible. Investors and analysts simply don’t have a standard framework. The problem is particularly acute for software-as-a-service (SaaS) companies

As Redpoint Ventures analyst Tomasz Tunguz notes, “If you sift through the 40+ public SaaS businesses, you won’t find mention of annual recurring revenue, churn, account expansion, or cash-collection cycles in most of them — even though these are the metrics the management teams employ to evaluate and steer their businesses.”

The new standards are based on one overarching principle: companies must recognize revenue when goods and services are transferred to the customer, in an amount that is proportionate to what has been delivered at that point. That’s pretty easy to do when you’re selling widgets but poses problems in the digital economy, where service relationships can change drastically over time.

For starters, subscriptions change frequently. When a company adds a few Salesforce seats, for example, contract changes are the norm. In my company’s experience, subscriptions contract undergo an average of four mid-term changes.

These changes can make the most basic compliance obligation — identifying a contract — a matter of some debate. In some circumstances, contract changes are handled as a modification to the existing contract, while in other situations, a separate contract is created.

Additionally, subscriptions are complex and rolled out over time. The handling of common subscription characteristics — e.g., evergreen subscriptions, nonrefundable upfront fees — becomes tricky when companies have to decide whether to recognize revenue right away or defer it.

For example, usage-based pricing, which is great for customers of Twilio or New Relic, can make determining your transaction price more complicated. And with any change to your service (adding, subtracting, or changing the type of service), your finance team will need to assess the accounting treatment.

Now for the bad news: I mentioned that these changes are right around the corner, didn’t I? The big public companies have about six months to get their act together, hence the opening quote from Google’s head of technical accounting.

The latest PricewaterhouseCoopers survey on the topic, which came out just two months ago, is not reassuring: 75% of public companies surveyed were currently assessing the impact of the new standard but had not yet started implementing it. Just over half of the companies had not even chosen a method of adoption.

Make no mistake: These new standards will result in winners and losers. Right now, lots of finance departments are either panicking to no effect or being dangerously ignorant about them right. Smart, progressive companies like ZendeskSurveyMonkey, and Dell EMC are already automating their finances, educating investors and recasting revenues. Others, not so much.

This isn’t just a back-office issue. For subscription-based companies, this has the potential to impact sales commissions, go-to-market strategies, compensation plans, product roadmaps, everything.

The doomsday clock is ticking.

Tien Tzuo is the CEO and founder of Zuora, a provider of commerce software for subscription-based businesses.