The Financial Accounting Standards Board (FASB) released the new revenue recognition standard, Accounting Standards Codification (ASC) 606, on May 28, 2014. Adopting ASC 606 can be a lengthy and labor intensive project. It may be especially painful for companies who have their IPOs derailed or postponed because they did not realize how long adoption would take or because they underestimated the complexity of ASC 606. While the process may be painful, there is no need for a successful IPO to be stalled or impacted because of ASC 606. The goal of this article is to highlight a few general adoption considerations companies should be aware of well before they attempt an IPO.
Before adopting ASC 606, there are two important decisions that you need to make: when and how to adopt the new standard. Public companies must adopt ASC 606 for reporting periods beginning after December 15, 2017, while GAAP-compliant nonpublic companies must adopt the new standard one year later, for reporting periods beginning after December 15, 2018. However, companies are allowed to adopt the standard as early as reporting periods beginning after December 15, 2016. There are two potential adoption methods for ASC 606: the Modified-Retrospective Method (“MRM”) and the Full-Retrospective Method (“FRM”).
To illustrate the different adoption considerations, we will refer back to the following case throughout the article. Provo Software Company (PSC) is a calendar year-end (12/31) GAAP-compliant private software company that offers only a single product and uses only one type of contract with its customers. PSC sells its on-premise software licenses with three years of ongoing technical support in a bundle for $1,500; the software and technical support are never sold separately. The estimated standalone selling price of the software is $750 and the estimated standalone selling price of the technical support is $750. PSC currently recognizes revenue under ASC 605 guidance, thus PSC recognizes the $1,500 pro rata over the life of the contract ($500/yr.).
However, under ASC 606 the same contract will be divided into two performance obligations: the software and the technical support. The two obligations will then be recognized separately as they are satisfied. The software will be recognized immediately upon delivery, and the technical support will be recognized pro rata over the three years. Therefore, in year one of the contract PSC will recognize $750 for the software delivery and $250 for providing technical support for a total of $1,000. In years two and three PSC will recognize only $250 for providing technical support.
Under the MRM, companies state their revenue using ASC 605 until they adopt ASC 606, at which point every subsequent period in their comparative financial statements, including the first period of adoption, should follow ASC 606. You will not restate revenue for the periods prior to the adoption; instead, at the beginning of the period when ASC 606 is adopted, a cumulative adjustment to retained earnings will be made. This adjustment is meant to true-up your equity balance to reflect what your retained earnings would have been if you had applied ASC 606 during all presented periods. You may choose to adjust retained earnings to reflect the difference in revenue that would have resulted from either (a) all unfinished contracts (under ASC 605) as of the adoption date, or (b) all contracts related to the years presented.
One issue you should be aware of when adopting ASC 606 is that under certain circumstances you may “lose” revenue; the revenue will never be reported in your financial statements as revenue and will instead be recorded as an adjustment to retained earnings. This “loss” or acceleration of revenue occurs when ASC 606 accelerates the timing of revenue recognition for certain contracts that were not yet completed under ASC 605. In this scenario, the revenue presented in the adopting period will be less than it would have been if you were still following ASC 605.
This can be illustrated by referring to our PSC example. If PSC choses to adopt ASC 606 on January 1, 2019 and uses the MRM, then it will show less revenue in 2019 than it would have under ASC 605 for contracts entered into after January 1, 2017, as shown in Figure 1 (assuming the contract was entered into on January 1, 2017).
In this scenario, $250 per contract would be accelerated and would not appear on PSC’s income statement, because it was instead added to retained earnings as an adjustment. As shown in Figure 1, revenue in 2019 was $250 using the MRM, but revenue would have been $500 under ASC 605. The $250 difference is found in the 2019 retained earnings balance. This difference could potentially impact a company’s ability to hit earnings targets, cause the public to worry about the company’s financial performance, or impact the company’s stock price even though nothing about the economics of the business changed.
The issue of “lost” revenue is especially important for companies who are planning to go public during the year they are adopting ASC 606. IPO investors are thorough when examining an offering company’s prospectus and often rely on revenue and net income metrics. Revenue growth rate, in particular, is one of the most important metrics when analyzing IPO companies. Investors may not understand that adopting ASC 606 can result in “lost” revenue, and they may discount an investment or not invest at all if they see volatile revenue or a decline in revenue growth. For these reasons, it is extremely important for you to be aware of the implications of adopting ASC 606 and thoroughly consider the appropriate method. If “lost” revenue cannot be avoided, you will need to clearly explain and present the revenue story and the impact adopting 606 has on the GAAP financial statements.
As part of the MRM you are also required to make additional disclosures, beyond the changes to the face of the financial statements. ASC 606 requires that you include a disclosure presenting your financial statements as if you had not adopted, the adjustments you made to adopt, and your post-adoption financial statements for the period in which you adopt ASC 606. You will need to keep two sets of books for the year of adoption to be able to make this disclosure. Therefore, prior to the adoption process it is important to establish financial reporting controls and designate employees who will maintain both sets of books. If these controls and responsibilities are not established prior to adoption, you will need to spend extensive time and resources to create the financial statements retrospectively which may impact your IPO.
If you choose to adopt using the FRM you will be required to restate each period in your comparative financial statements using ASC 606, and reevaluate every outstanding contract during the presented periods using the new guidance. This means you will need to evaluate which contracts had separate (distinct) performance obligations, variable consideration, remaining obligations, and other factors that are important under ASC 606 that were not considered under ASC 605. For more detail on these aspects of ASC 606 consider visiting RevenueHub.org. Once you have identified all the differences between the accounting for your company’s contracts under ASC 605 and ASC 606, you will need to calculate the amount of revenue that would have been recognized in each period under ASC 606 and restate your financial statements accordingly.
While applying the FRM may require additional time and resources, it may also help you mitigate negative adoption impacts, such as “lost” or accelerated revenue. Still, “lost” revenue in the very first period you present is unavoidable. For example, if PSC were to adopt ASC 606 using the FRM on January 1, 2019 it would experience “lost” revenue in 2017 for any contracts that were still outstanding between 2016 and 2017 rather than in the year it adopted ASC 606. Figure 2 demonstrates what revenue and retained earnings would look like if PSC were to adopt ASC 606 using the FRM for two contracts: a contract that started in 2015 and a contract that started in 2017. It should be noted that 2015 and 2016 are shown for illustrative purposes—only 2017, 2018, and 2019 would actually appear on the financial statements.
During 2017, PSC would have $250 in accelerated revenue that would instead appear in retained earnings, just like it would have if it used the MRM. For contract 1, PSC would have $250 less in revenue under the FRM than under ASC 605, and PSC would have $250 more in retained earnings. Contract 2 began the same year that PSC adopted ASC 606, leading to a different impact than for contracts that began before adoption. Using the FRM, the company loses revenue during the first period presented—while on the other hand, using the MRM, the company loses revenue during the period it adopts ASC 606.
For contract 2, there is a difference in the amount of revenue recorded in 2017 ($1,000 and $500). However, this difference is not due to any “lost” revenue but results from a change in the timing of revenue recognized (accelerated under ASC 606).
As discussed earlier, adopting ASC 606 may negatively impact the revenue you report on your prospectus. However, if you adopt using the FRM you may be able to mitigate the perception that your company’s revenue growth is declining, because your first period’s revenue will be lowered by the accelerated revenue during adoption and every subsequent period will remain unaffected.
In addition to choosing the appropriate adoption method, you should give careful consideration to the timing of your ASC 606 adoption. When you begin the IPO process you will need to file a form S-1 with the Securities and Exchange Commission, which will include audited financial statements. As mentioned earlier, private companies need to adopt ASC 606 for periods after December 15, 2018, which means that until you begin the IPO process you are not required to adopt ASC 606. However, with the exception of emerging growth companies (EGC)—companies with less than $1 billion in total revenues—entities filing with the SEC must file as if they had been public companies. This means that when you file your S-1 it must appear as if you adopted ASC 606 at the public company adoption date. Therefore, if you are a non-EGC private company who has not adopted ASC 606 and you intend to go public after December 15, 2017 you will need to either (1) adopt ASC 606 during the IPO process or (2) early adopt ASC 606 before you start your IPO.
Deciding when to adopt ASC 606 is especially important if the majority of your customer contracts will result in “lost” or accelerated revenue similar to the Provo Software Company example illustrated above. In this case, if you wait to adopt ASC 606 until your IPO, you will have to file an S-1 with a significant amount of “lost” revenue.
If you are an emerging growth company, you have more options regarding when to adopt ASC 606 than non-EGC companies. EGCs can chose to adopt ASC 606 (1) at the private company adoption date, (2) at the public company adoption date, or (3) at the early adoption date. Therefore, an EGC that completes an IPO in 2017 or 2018 may wait to adopt ASC 606 until January 2019. However, you should be aware of how ASC 606 adoption will affect your future financial statements. As part of your financial statements you must include a disclosure (known as a “SAB 74” disclosure) detailing company-specific impacts of ASC 606 adoption. While it may be more important to avoid dramatic changes in revenue during an IPO, changes in earnings due to revenue recognition will be impactful at any period.
Adopting early may also lessen the impact of ASC 606 for EGCs. EGCs may elect to present only two years of selected financial statements as part of their S-1. For example, if an EGC is hoping to IPO in 2019, it could elect to present only financial statements from 2018 and 2019 in its S-1. Therefore, adopting early could mitigate the negative affects of ASC 606, as the periods presented in the prospectus would be post-adoption periods.
Private companies with less sophisticated accounting functions may also want to consider early adoption. Adopting ASC 606 is a time consuming task for any company, and companies without sophisticated accounting functions may spend much more time on the transition than expected. Adopting ASC 606 early will ensure that your IPO will not be held up by any unexpected obstacles in your financial reporting because of revenue recognition. Many private companies have begun adopting ASC 606 early to avoid any hiccups during the time-sensitive IPO process.
Other Accounting Impacts
In addition to the “lost” revenue discussed above, adopting ASC 606 can have many possible accounting impacts. The following is a list of potential impacts you may see as a result of adopting ASC 606:
- Contract acquisition costs, such as sales commissions, will now be capitalized and amortized over the contract period or customer life. Under ASC 605 contract costs were often-times immediately expensed.
- Contract revenue recognized using the completed contract method in many cases may be recognized earlier, as services are delivered.
- Loyalty points earned by loyalty program members will be valued using a relative selling price approach rather than an incremental cost method. Under the selling price approach, a portion of each sale related to loyalty points earned will be deferred and recognized as revenue when the points are redeemed.
- Revenue from the licensing of intellectual property categorized as symbolic IP will now be recognized over-time. Under ASC 605 this revenue was often recognized at the inception of the licensing contract.
- Revenue subject to guarantees may now be recognized when delivered, as opposed to being deferred under ASC 605. Adjustments in estimated profit will be recognized in the period they are identified (cumulative catch-up method), rather than recognizing the impact of an adjustment prospectively over the remaining contract term.
These are examples of only a few of the many potential impacts ASC 606 may have on your company depending on your specific company and industry. For a more detailed list of potential impacts please see the RevenueHub article related to your specific industry.
Time and Costs
Implementing ASC 606 will be a time consuming and expensive process. Depending on your company’s industry, accounting organization, and typical contract type the implementation process will vary significantly. Our sister website RevenueHub addresses the majority of the questions you will have about adopting ASC 606 in the article: Implementing ASC 606. We recommend you visit the RevenueHub website, specifically the aforementioned article, as you begin to consider adopting ASC 606.
If you start planning how and when you want to adopt ASC 606 and budget the appropriate amount of time and resources now, you will be able to complete a successful IPO without any interruptions from ASC 606.