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All you financial analysts covering firms in the software sector, this one’s for you: an in-depth look at how those firms are preparing for the new accounting standard for revenue recognition, coming to a balance sheet near you by the end of this year.

The report, co-authored with our brothers-in-arms at Radical Compliance, is on our Research page. You can download a free copy there. To experience the data yourself, click here. We have a few highlights here.

We looked at several hundred companies in the software sector to see how they are implementing the new standard, which goes into effect at the end of this year. We specifically wanted to examine those software firms with relatively high deferred revenues for long-term software sales. Those contracts are likely to see big changes under the new standard, which could lead to material changes in the timing and nature of software firms’ revenue reporting.

Take Microsoft as an example. Historically, the company would sign long-term contracts with corporate customers for its Windows operating system. Much of that revenue, however, would be deferred revenue locked away as liabilities on the balance sheet. Microsoft couldn’t recognize those liabilities as actual revenue on the income statement until it hit appropriate milestones in the long-term contract (say, an annual upgrade of the customer’s Windows OS).

The new revenue standard abolishes that holding pattern, so software companies like Microsoft can recognize all the revenue from those long-term contracts immediately. That can lead to a big shift in the software company’s revenue picture. (We should stress, however, that Microsoft has other sources or revenue, such as LinkedIn membership fees, that won’t affect overall financial statements at all.)

How big? Microsoft adopted the new revenue standard with its earnings report released on Aug. 2, and restated its prior financials (in millions) from the old standard to the new. Take a look:

Year Ended Original Revenue Adjustment New Revenue
30 June 2016 $85,320 $5,834 $91,154
30 June 2017 $89,950 $6,621 $96,571

In other words, the new revenue standard led Microsoft to experience a material shift in financial reporting. The company isn’t “losing” any money because of the new standard, but a lot of future revenues will now be recognized immediately, rather than be bottled up as liabilities on the balance sheet.

So that’s Microsoft. What about everyone else?

What We Found

Our report looked at more than 400 companies that list Microsoft as a peer. We tried to identify those companies with the largest amounts of deferred revenue relative to their current liabilities; they will be the ones most likely to experience a sudden, big shift when they implement the new standard. Then we looked at their footnotes to see what they’ve been saying about the new standard so far— including the possibility that the numbers suggest a big impact, while their footnotes are a lot of “we are still assessing.”

Some factoids:

  • For the software sector overall, the average ratio of deferred revenues to current liabilities across the last three years has been 43 percent;
  • Among 400 companies that count Microsoft as a peer, we found 11 with “DR/CL ratios” above 100 percent (that is, deferred revenue was larger than all current liabilities), and another 27 where the ratio was above 80 percent;
  • Within that group of 11 software firms above 100 percent, seven said they were still evaluating whether the new revenue standard might have a material effect on their financial picture;
  • Within the second group of 27 companies, however, nine of the 27 said the new standard will have a material effect, and they used more words to discuss the new standard than the first group of 11 firms.

What does all this mean? First, that revenue fluctuations in the software sector could become more volatile, since more companies will be recognizing the full value of contracts immediately. They will lose the smoothing effect that existed in previous years, where companies recognized the value of long-term contracts incrementally.

Second, financial analysts may want to ask software companies they follow just how prepared those firms are for the new standard. Some firms in our report seem like they’d be in for a big change: lots of deferred revenue, that until now had been recognized “ratably” across multiple years, will now hit the income statement in one quarter.

We should also remember this study is a snapshot of disclosure in 2016 reports. Companies are disclosing more all the time, as implementation deadlines near. In a separate study we did looking at the 30 companies in the Dow Jones Industrial Average, 2014-2016, they did indeed disclose more and more over time.

Yet here we are, four months away from the new standard’s effective date, and some firms do remain uncertain about exactly when they’ll implement the new standard, what method they’ll use (they have two choices), what the possible effect to revenue numbers might be, and what effect the standard might have on other issues such as sales compensation agreements, internal control, tax reporting, and the like.

So by all means, dive into our paper. It’s a good take on what might happen next in the software sector, and a good blueprint for how you can use Calcbench to map out possible consequences for other companies and sectors.

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