Technology industry revenue - To recognise upfront or overtime?

In a nutshell

It was widely known that the technology industry would be significantly affected by the revenue recognition standards, IFRS 15 and ASC 606: Revenue from contracts with customers (2018). Whilst the standards provide significantly more guidance over the treatment of revenue, the application of these accounting standards is still proving to be a real challenge. These standards have caused significant debate, particularly in technology companies selling licenses over a fixed term or selling a bundled product. For many companies, the biggest impact has been on the recognition of revenue or profits, potentially resulting in huge revenue or profit swings year on year.

If your company sells licenses (particularly if these are hosted on premise) or bundled contracts of “license + service”, this article aims to provide additional insight and guidance into a number of the key judgements. It also looks at the implications of the accounting standards from a corporate finance and taxation perspective.

Overview

As the name of the standards suggests - Revenue from contracts with customers - the starting point is to understand the terms of the revenue contract. It is also important to consider whether there are any further enforceable rights and obligations to the customer that may arise from other promises implied by an entity’s customary business practices, two or more contracts entered into or near the same time with the same customer and/or other oral or written agreements.

For example, a company may sell software products and the revenue contract does not obligate the company to provide any future software releases. Whilst the company most likely would have a legal obligation to ensure the product operates exactly as how it was contracted, the reality may be that it is customary for the company to release unspecified future software releases given the rapid pace of technological advancement or some other reason. Management should therefore consider the context of the contract, wider promises made to the customer (both explicitly and implicitly) and the customer journey – all of which affect the expectations of what their customers are purchasing.

Smith & Williamson view:

In accordance with the new revenue recognition standards, management are required to identify their performance obligations that arise. Once these have been identified, management should then assess whether to combine multiple performance obligations into a single ‘distinct’ performance obligation.

It is common that the software is a distinct ‘right to use or on premise’ licence, with revenue recognised at the point in time when it is transferred, while the future software releases or other support services are generally delivered over time. However, there are certain circumstances where the licence and future software releases or other support services are combined into a single distinct performance obligation.

There are a number of factors to consider in forming a judgement on whether to combine multiple performance obligations into a single distinct performance obligation. These include:

Investor considerations

When the revised revenue standards were first announced, some investors strongly believed that the overall accounting standards would not change the fundamentals or how companies manage and operate their business. However, revenue has always been an important link between a target company’s accounting information and its valuation.

It is important to note that analyst valuations are not just based on future cash flows but also on profitability. It would also be key to understand what the changes have been to revenue numbers as a result of real growth and what proportion stems from the accounting standards.

The increased complexity and volatility of implementing the revenue accounting standards has compelled investors and acquirers to focus on metrics that are less susceptible to change. As such, many companies have introduced non-GAAP measures namely adjusted cash flows, annual contract values, adjusted recurring contract values, adjusted EBITDA and adjusted deferred income metrics.

Another consideration relates to the differences between UK GAAP (FRS 102) and IFRS. The reality is that whilst UK GAAP is not as prescriptive as IFRS, the principles underpinning both standards are fundamentally consistent. We see a large number of companies incorrectly applying UK GAAP principles which results in significant issues and delays during a due diligence exercise.

Smith & Williamson view:

Taking a step back, the fundamental result of the revenue accounting standards is essentially a matter of timing for when revenue hits the income statement, but cash flow is largely unchanged because contract payment terms will remain the same. Investors will look through accounting revenue policies and try to understand the income and cash flows attributable to the business.

We continue to expect non-GAAP analysis and statistics outside of the accounts as management explains the individuality of their business model.

Tax considerations

Generally speaking, the corporation tax charge is based on the measurement of profit under GAAP, subject to specific exceptions. Therefore, any changes in the timing or measurement of revenue for accounting purposes are likely to have a direct impact on corporation tax.

If the change to revenue recognition means that revenue is recorded upfront, the corresponding tax charge will be due earlier, thus impacting the timing of any corporation tax payments. Companies should consider modelling any changes from a tax perspective to ensure that tax payments are forecast accurately.

For many companies, these cash flow implications could also impact their ability to pay dividends or comply with the terms of loan covenants.

To the extent that the adoption of new or amended accounting standards leads to prior period adjustments, consideration should be given to the tax implications. If the change has arisen due to a previous ‘accounting error’, the relevant tax return will need to be resubmitted and any additional tax liability will be due immediately. If the change is instead due to a ‘change in accounting basis’, catch-up tax payments or deductions may arise in the first period of adoption. This change should also be factored into tax payments and forecasts.

Any changes to revenue recognition should also be considered in conjunction with any deferred tax assets, such as the use of carried forward losses.

Smith & Williamson view

As the starting point for calculating corporation tax is the accounting position, the timing of revenue recognition has a direct impact on the timing of tax payments.

If revenue is being recognised before cash is received from the customer, the company can effectively incur a dry tax charge where tax is due and no cash is received. The cash flow position should be managed closely.

It is also important to consider any knock-on implications such as the impact on deferred tax, especially now that some companies need to consider recognising this at 25% (the future expected tax rate from April 2023).

Sources 

^1. Microsoft Corporation Annual Report 2020 - https://www.microsoft.com/en-us/Investor/annual-reports.aspx
^2. NortonLifeLock Inc 2020 Annual Report - https://investor.nortonlifelock.com/About/Investors/financial-information/Annual-Reports/default.aspx
^3. Oracle Corporation, Fiscal year 2020 form 10-K Annual Report - https://investor.oracle.com/sec-filings/default.aspx
^4a. The Sage Group plc FY20 Annual Report & Accounts - https://www.sage.com/investors/investor-resources/annual-report/
^4b. SAP Integrated Report 2020 and Annual Report on Form 20-F - https://www.sap.com/investors/en.html

DISCLAIMER
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

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