Given the complexity inherent in the new revenue recognition standard, it’s not surprising that only a small handful of large companies have signed up as early adopters.
All public companies are required to adopt the new standard as of their first reporting period that begins after Dec. 15, 2017. Companies were also given an option to begin doing so exactly one year before the required date. But only five S&P 500 companies have done so.
Three of the five companies — Alphabet, Raytheon, and UnitedHealth Group — all said in their 10-K filings for 2016 that they did not expect the transition to the new standard to have a material affect on their financial results. General Dynamics, on the other hand, reported a wide variety of impacts from the new standard.
But the most interesting case may be Workday, which began accounting for revenue under the new standard on Feb. 1.
The software-as-a-service (SaaS) firm said in its 10-K for its 2017 fiscal year, which ended Jan. 31, that it could not at that time estimate the financial impact of adoption. However, in its earnings call for the recently completed fiscal year, Workday reported a gain in non-GAAP operating profit margin as a result of the transition. That margin was 1.9% when accounting for revenue under the old revenue-recognition standard (ASC 605) but 3.3% under the new one (ASC 606, which will supersede 605).
That’s not necessarily a plus for Workday. It’s an accounting change, not a business-model change, and it doesn’t much impact the company’s cash flow, value, or future prospects, says Robynne Sisco, Workday’s finance chief, in an interview with CFO.
Indeed, she says the only thing the margin increase does is “raise the bar for us going forward.”
“We are still committed to incremental profitability gains year over year, and even though the number is bigger we still need to improve on it [in the new fiscal year],” Sisco says.
The new standard applies to revenue earned from contracts with customers, and Workday, as a SaaS company, has at least one contract with each of its approximately 1,500 customers. Among “pure-play” SaaS companies — those that don’t deliver on-premises software to some clients — Workday’s revenue is the second-greatest after that of Salesforce.com.
What caused the change in margin? Under the old standard, with regard to contracts for delivery of service over time, companies could only recognize as revenue amounts actually billed to a customer. Under the new standard, so long as a company believes that a customer is creditworthy, the company is allowed to recognize contract revenue ratably over the entire contract term.
“There are other things that can influence the timing of revenue recognition under the new standard, but all other things being equal, it divorces the invoicing schedule from the revenue schedule,” says Sisco.
The new standard also requires a company to capitalize certain customer-acquisition costs — largely sales commissions — and amortize them over the life of the contract. Therefore, not only did Workday recognize more revenue for fiscal-year 2017 under the new accounting rules, it also recorded lower expenses.
“You can expect to see something similar with other companies as they adopt the new standard,” Sisco notes.
Why Be Early?
Workday decided to become an early adopter for a couple of reasons. For one, Sisco says, the company strives to be transparent and had been getting an increasing number of questions from investors about how the new standard would affect its earnings. “We thought that the sooner we could provide transparency around what [ASC] 606 meant to Workday and the analyst community, the better,” she says.
In fact, to maximize transparency, the company actually did more than it was required to do as an early adopter.
Under the adoption method Workday chose (from the two choices available), companies are required to restate their financials for the prior two fiscal years, using the new accounting rules, and present the restatements along with an accounting under the old rules.
However, companies are required to do so only as they report going forward. In other words, even as an early adopter, Workday was under no obligation to report any restated financials until filing its 10-Q for its current quarter, which ends on April 30. Even then, it’s required only to present a restatement for the corresponding quarter of its previous fiscal year.
Workday, though, chose to update its financials for the two prior years, and each quarter within them, in its reporting for its 2017 fiscal year that ended Jan. 31.
Aside from the transparency, there was “maybe a larger reason” for the early adoption as well, Sisco adds. That is, it’s a policy at Workday — a maker of financial management and human resources software — to use any new functionality internally before providing it to customers through its twice-a-year software updates. And since the company developed software functionality designed to help customers transition to the new revenue recognition standard, it had to try it out “live” before delivering it to the customer base.
“Now when our customers start using our features and functionality to adopt [ASC] 606 in their own companies, we’re the proof point that the functionality works,” Sisco says. “We can act as an adviser to customers and give them lessons learned as to the best ways to use the product to adopt the standard and how they might want to structure their adoption project.”
No Small Feat
Sisco says that from Workday’s experience, a key takeaway for companies as they adopt the new standard is not to underestimate the amount of effort it will take. Those with calendar fiscal years, which will be required to adopt the new standard on Jan. 1, 2018, should start the project soon if they haven’t already.
Workday started working on the transition “in earnest” in September, according to Sisco.
“It’s a significant project,” she says. “You have to go back and look at a good portion of your customer contracts under a new lens, even if it’s just to draw the conclusion [in any particular case] that there is no impact.”
The review of customer contracts, as well as customer-acquisition costs, “is one area where technology can’t help you that much,” she observes.
Companies are allowed to stratify their contracts into populations of similar contracts, and look at a few to determine whether any changes apply under the new standard. “But then you’ve got a longer goal, which is figuring out how to redo your financials [for the prior periods] and how to account for your revenue going forward,” says Sisco.
(Getting in a plug for Workday’s cloud software, she suggests that companies using legacy financial systems that have customized solutions “are likely going to have to go through a re-customization project to handle the accounting under the new standard.”)
Another thing companies have to re-evaluate is the allocation of revenue between “linked contracts.” For example, for companies that have subscription contracts with customers, and, as Workday does, separate “professional services” contracts to help the customers implement the software, the new standard has different rules for allocating revenue between the two contracts.
“You can have subscription revenue move to professional services revenue, and vice versa, impacting the classification of revenue on your income statement,” Sisco notes.
Not all of Workday’s contracts must be accounted for differently under the new standard. “It depends on the specific terms of contracts,” she says.