An update to generally accepted accounting principles (GAAP) for US companies is turning out to have particularly large consequences in parts of the tech industry, which is having to overhaul the way it reports revenues and costs.
As companies announce their second-quarter earnings in the coming days, analysts will be watching closely for clues as to how their financials will be affected by the far-reaching change, which public companies must adopt by the beginning of next year.
“There’s a real risk that Wall Street analysts will misunderstand the numbers as they’re being restated,” said Tien Tzuo, chief executive of Zuora, which makes software for companies that have subscription businesses.
A handful of companies have already switched to the new standard, including Alphabet and Workday, and accountants say many others are scrambling to understand how the changes will affect their top and bottom lines.
In some cases, a change in the timing of when costs are recognised will lead to higher profits under GAAP accounting, though other companies will see no change at all.
One of the more dramatic impacts will affect car-booking services such as Uber, a private company whose GAAP revenue drops by more than half when it adopts the new standard, which it plans to do this year.
Uber’s first-quarter revenue this year was $3.4bn under old GAAP accounting, but it says that under the new rules its revenue would have been just $1.5bn for the same period. Uber has already started sharing the lower figure with investors.
Under the old standard, car-booking services such as Uber and Lyft counted their commissions from regular rides, plus the entire fare of carpool rides, as revenue. Under the new standard, only the commissions from both regular and carpool rides will count as revenue.
The shift is due to changes to the “principal versus agent” rules that determine when a company is acting as a principal and when it is acting as an agent. The car-booking services were previously considered the “principal” for carpooled rides. As private companies, they must adopt the new standard by the beginning of 2019, although Uber has moved to do so much earlier.
The new standard, known as Revenue from Contracts with Customers, is designed to narrow the distance between US GAAP rules and International Financial Reporting Standards (IFRS).
“We are going from a lot of . . . rules that are principles based, to more judgment, more estimates, as well as a lot of disclosure requirements,” says Eloise Wagner, partner at Ernst & Young. “It is a big change.”
The software industry is set to be one of the most deeply affected. Operating under highly specific industry rules for when revenue can be recognised, and with many companies in the midst of a transition from upfront licence sales to a software subscription model, the move to an entirely new accounting regime will force complex changes.
The precise effects will depend on the fine print of each company’s contracts, Mr Tzuo said, many of them developed with older accounting rules in mind.
Under so-called “ramp” deals, for instance, customers pay more in the later years of a contract. But under the new rules, the revenue recognition will have to be spread evenly over the period, resulting in more sales being reported earlier. And companies that sell both hardware and software — often accounting for each element separately — will have to treat them as a single sale if they are judged to be part of a single IT system.
Microsoft has said the impact on its revenue will be material, as sales of Windows 10 licences, which are currently treated as a rateable licence fee spread over a number of years, are all recognised upfront.
Cloud software companies, meanwhile, could benefit by deferring more of their costs until future years.
With marketing and sales costs amounting to more than half of total revenues for some software-as-a-service (SaaS) companies, the impact on high-growth companies in particular could be significant, said Mr Tzuo. Salesforce, the biggest SaaS company, has said that it will delay the recognition of more of its sales commissions, something that will improve its reported profitability.
Even when the absolute numbers are not large, the impact may still be significant. Most SaaS companies operate at a loss or with very marginal profitability, making any boost to their bottom lines noteworthy.
Workday, the first SaaS company to adopt the new accounting rules earlier this year, said the change had lifted its pro-forma operating profit margin to 3.3 per cent in the latest financial year, compared with the 1.9 per cent it would have reported under the old rules.
Meanwhile, analysts and investors will have to be on the look out for idiosyncratic effects — and to make sure they do not mistake higher reported revenues for a real change in the underlying business.
Amazon has said that the new standard means that it will recognise revenue sooner when it sells electronic devices such as Kindles via non-Amazon stores, and will also recognise revenue sooner from the unused portion of gift cards.
Get alerts on Accountancy when a new story is published