A new accounting rule recently went into effect that is already changing how companies account for and report on revenue. ASC 606 or “Revenue from Contracts with Customers” standardizes and simplifies how companies record revenue in customer contracts and covers how businesses report the nature, amount, and timing regarding contracts with customers. The rule went into effect for fiscal years beginning after December 15th, 2017.
Preliminary Analysis
Preliminary analysis of earnings releases identified about 70 companies that noted ASC 606 in the context of the 2018 guidance. Out of the 70 companies, 20 have quantified impact on revenue guidance and ten companies quantified effect on the expected 2018 EPS.
Based on a preliminary sample, companies with negative impact were more likely to quantify the impact on 2018 EPS. For six out of the ten companies, the standard is expected to have negative impact, and for four companies, the impact on 2018 EPS guidance is expected to be immaterial.
In subsequent earnings reports we will start to see the impact of ASC 606 in financial statements, as nearly 80 percent of the Russell 3000 firms should have adopted the new standard by January 1st, 2018, if their fiscal year ends on or around Dec. 31. For the other 20 percent, the adoption date depends on their fiscal year end.
Reporting the Impact on Earnings
Importantly, the rule may improve earnings results for companies that sell subscriptions or licenses or other recurring services.
Take Activision Blizzard [ATVI] as an example (get a free summary Watchdog Report at WatchdogResearch.com). Under the previous law, if Activision Blizzard sold a 12-month software product license in June 2016, it could only apply six months of revenue to its books. It would not be able to count on the next six months of revenue until 2017. Under ASC 606, it can count all the revenue at once, improving the 2018 results going forward.
We will be required to recognize as revenue a portion of the sales price upon delivery of the software, as compared to the current requirement of recognizing the entire sales price ratably over an estimated service period.
Considering many life-science sector and technology companies license products, the new standard will likely improve their financial results when they release their first-quarter earnings reports.
Not all companies noted the new revenue recognition rule in their 2018 guidance discussions. And even the companies that provided the reference had no consistency in how they disclosed it.
As an example, let’s look at two companies in the telecommunications industry that have already provided references to how they are reporting the impact of the rules.
Verizon Communications Inc [VZ] (free summary Watchdog Report available on WatchdogResearch.com) is showing earnings-per-share guidance before the impact of the new revenue recognition standard. For 2018, Verizon expects the following:
Low single-digit percentage growth in adjusted EPS, which includes the dilutive impacts from a full year of depreciation and amortization costs from 2017 acquisitions, the Straight Path acquisition expected to close later in the first quarter, and the ongoing impact of last year’s data center divestitures. This is before the impact of tax reform and the revenue recognition standard.
Meanwhile, the guidance provided by AT&T Inc [T] (free summary Watchdog Report available on WatchdogResearch.com) explains how the new standard affects EPS, but not by how much.
On a standalone basis, including the impact of tax reform and the new ASC 606 revenue recognition standard, we expect in 2018: Adjusted earnings per share in the $3.50 range.
Accounting for the New Rule
Companies may use two different methods to account for the impact of the change in the rule, complicating comparisons to previous results.
The first method a company can use to account for the effect of the adjustment is the full retrospective method. With this method, the company restates all their revenue and expenses for the prior period. The allows for easy comparisons between current and past revenue, and the impact of the adjustment can be clearly seen. This is especially helpful if the impact on financial statements is material.
The second method to account for the adjustment is a modified method. Using this method, the company adjusts retained earnings in the current period and recognizes revenue under ASC 606 going forward. This method is easier to implement and most of the companies are likely to use this option. However, unlike the retrospective method, it does not allow for easy historical comparisons.
Regardless of which method the company adopts, trying to get clarity on a 2018 revenue and earnings-per-share growth won’t be easy. Even the retrospective method that allows for a historical perspective doesn’t always help going forward. It will be difficult to measure the impact of the adjustment on the 2018 outlook and to assess how much revenue growth is due to the change in the accounting rule.
Analysts should be aware of that some companies may have changed the way they report guidance and be careful to ask to what extent financial results may have improved due to the new accounting rule.