Counting down to ASC 606
There will be little New Year’s Eve celebrating but much potential morning after hangover for US businesses not preparing for ASC 606, the Financial Accounting Standards Board’s (FASB) new rules about revenue recognition set to go into effect on January 1, 2018. The news is much the same for Europe though with only the rule’s name being different; for them it will be IFRS 15.
A recent KPMG report, “The Deadline Is Approaching for Accounting Change” has some hard numbers and equally hard facts, among them, the change is hard to do. Where have we heard this before? Some findings include,
- Even though the effective date for revenue recognition is just months away, 60 percent of public companies said they are facing challenges staying “on track,” and a similar percentage of private companies felt the same way.
- Only 6 percent of respondents believed they were faced with minimum impact requiring “little of no action” on their part
- Total expected implementation costs had increased from the prior year for 57 percent of the public company respondents
- Most respondents did not think the new rules would have a significant impact on their company’s tax issues
- Internal communications need to be improved; 33 percent said C-level executives had little or no involvement in the process
Additional data shows that the largest clusters of companies were either still in the assessment phase (39 percent) or in implementation (35 percent), only 6 percent said their implementation was complete.
With so much foot dragging, it’s a reasonable bet that a healthy number of companies will miss the January 1, 2018 implementation deadline. Then what? To put it all in perspective, many companies don’t have a revenue recognition issue and 57 percent, according to the survey, say their organizations are not planning for system changes for the new standard. This may be a good indicator of the percentage of companies throughout the economy don’t rely on subscription business, at least not yet.
But it’s hard to see what companies are in this group. Even companies as old school as Caterpillar, the earth moving equipment maker, have significant initiatives in offering their products as services. So, a logical follow up might be, why aren’t these companies more focused on the economic opportunity provided by subscriptions?
The answer might lie in the way that subscriptions have been handled so far. With few standards for revenue recognition or definitions for how sales are booked and commissioned, it’s likely there are companies that offer some form of subscription services that don’t think the new rules apply to them. But since the new rules also apply in the EU and there are penalties for non-compliance, we might look for a sudden burst of activity in this area after the first of the year as the laggards finally discover that the new rules really do apply to them.
To be fair though, there really are companies for whom the new accounting standards really are a non-issue. Zuora, the subscription billing and financial management company trying to shepherd as many businesses as possible into the new standards, has developed a website that tracks many big-name companies that might have an issue with the new rules. Indeed some do but it’s surprising the number of them that don’t foresee an impact on company cash flows, including Salesforce, Caterpillar, General Electric, and many others. Perhaps that’s because these companies are so big that they’ve had to deal with revenue recognition for a long time. Or perhaps they’re so rich that they’ve been tracking the issue and getting ready for it. The information is gleaned from public records of 10-Q filings so it’s reliable.
What’s a company to do if it doesn’t fall into any of these buckets? It’s not too late and Tien Tzuo, CEO of Zuora has this advice.
“Even if a company has not yet started their ASC 606 project, there are a few things they can do to get set up for reporting under the new standards immediately. First, get an accounting firm to do an assessment and determine the risk of impact on revenue. Then, identify the timeframe required to fully automate revenue recognition to reduce that risk. If that’s not possible, a company will be forced to suffer with expensive, manual-intensive labor to report on time. Doing manual calculations will be error prone and can cause restatements later due to complexity of 606. If you’re stuck doing manual processing now, think about launching an automation project at the same time to collect data and analyze it for the first reporting cycle under 606.
Ok, it’s time for the other shoe to drop. All of the above is for the consumption of public companies. If you work in a privately held company, and especially if you’re one of those large pre-IPO outfits called unicorns, you’ve got an extra year to figure this all out and you ought to do it ASAP. As Tzuo points out the danger for the unicorns is this,
“Deloitte released a new survey of 3,000 companies indicating slow progress among private companies on implementation of the new revenue standard may delay IPOs. That’s a bad sign, especially when Fortune’s Data Sheet reported that the IPO window is now again open for tech companies following successes of Roku, CarGurus and MongoDB.”
Imagine working for ten years to build a company and bring it public but then failing to do so at the optimal time. Come to think about it, don’t, it’s too depressing. Better to get to work on finding your optimal solution. It’s out there.
Subscription economy’s maturation
A lot happens in a decade. Bill Gates, among others, once said that we over estimate what we can do in two years and underestimate what we can do in ten. 2017 is a particularly good time to stop paddling and look back at what’s been going on in the last decade and while we will all have our favorite memories, there’s one in CRM that stands out more for me than others.
After all 2007 was the year of the iPhone as well as the year before everything in the financial world began going down in a big way. There was barely any social media to speak of—Facebook was founded in 2004 but only in 2006 could anybody over the age of 13 join. Twitter was founded in March of 2006 but while social was making waves in 2007, the introduction of the iPhone helped make it the huge part of our lives it is.
But as one who has been writing about CRM and especially SaaS, 2017 marks the tenth anniversary of Zuora’s founding. You might think that wasn’t significant but just as the iPhone made social networking a big deal, Zuora had a similar effect on the SaaS business. Sure there were already big companies like Salesforce.com in the space by 2007, they’d even gone public a few years before.
But there was a looming problem in SaaS that was either being ignored or avoided, and it was creating drag on the whole industry. The problem was that although SaaS businesses were successful, they were scrambling each month to get their billing out. In 2007 even the best SaaS companies were using a combination of spreadsheets and archaic ERP systems that couldn’t fathom the idea of a recurring charge. ERP could do services but not the recurring part and spreadsheets aren’t systems, at best they’re the equivalent of life vests for business processes.
So along came K.V. Rao, Cheng Zou and Tien Tzuo, veterans of WebEx and Salesforce to tackle the problem. I am not certain if Zuora was the first company of its kind, but it certainly put a floor under the industry in a way that competitors didn’t. That floor looked a lot like Salesforce. When Salesforce got started subscriptions were thought to simply be another delivery mechanism for software and not the revolution they turned into.
Similarly, Zuora didn’t simply approach the subscription billing problem as, well, a billing problem. Zuora saw a revolution in the making and not just in software as a service. They saw subscriptions as a new economic entity, a way to bend the cost curve downwards that would expand markets by vastly increasing demand. Importantly, though, the subscription difference has been that while markets expanded they did not necessarily commoditize, which might have been the first time in history that’s happened.
Under more normal conditions that have prevailed throughout history, commoditization involved elements of mass production as well as finding ways to cheapen a product. Mass production takes labor out of making something reducing costs. Cheapening products can take many forms, for instance, you can remove features or substitute materials or components in the process shortening the product’s useful life. You can also curtail services, which are expensive to provision when using employees rather than systems.
Until subscriptions, that was the reality of commoditization but by their nature, subscriptions do none of that. The same grade of product delivered as a service is available to all, though the current reckless actions by the FCC to degrade net neutrality may be a retrograde step in the direction of cheapening the Internet. Everyone also pays the same base price though there’s still opportunity for creativity when it comes to volume discounting. Most importantly, development and maintenance in many subscription industries are ongoing and if they aren’t, like when you subscribe to a car through a lease, at least the service level remains high. The reasons are all the same, subscription vendors are always in the hunt for the renewal.
Zuora saw subscriptions as the revolution they are and that’s one reason they’re one of Silicon Valley’s unicorns, a startup worth more than a billion bucks on paper. Undoubtedly, we’ll see that valuation tested at some point through a public offering but for now it’s worth recalling that the revolution is continuing. U.S. and international financial accounting boards that set standards for how businesses report their financial activities have recently (after more than a decade) announced standards for how businesses report on recurring revenue, which goes to the heart of the industry.
The new rules ASC 606 (U.S.) and IFRS 15 (Europe) begin going into effect next December. As I’ve written previously, Zuora has acquired Leeyo a revenue recognition specialist company to prepare its customers for the transition. It’s not the first acquisition for Zuora, which has been steadily innovating and acquiring businesses as needed to build out its platform and support the subscription economy.
Zuora has come a long way since its founding ten years ago but so has the industry, so have we. Gate’s original insight should probably be amended because not only do we underestimate what can be done in a decade, we absorb new technologies so fast that a decade can cause amnesia about the way things were just a short while ago.
New accounting rules change subscriptions
CFOs have a new 800-pound gorilla sitting in the corner, as if they needed another one. Actually, the really lucky ones who oversee operations in Europe and the U.S. will have two. ASC 606 and IFRS 15 are new accounting rules that describe in great detail how subscription vendors should recognize beginning in December 2018 and we should all care about them.
Since the dawn of the subscription economy companies like Salesforce, Zuora, and loads of others have preached the advantages of buying things as services rather than as traditional goods. Subscribers pay only for what they use, never worry about some of the more intricate and arcane aspects of implementation, change, and maintenance because just about all those things are responsibilities of vendors. But although subscriptions have been a staple of business since the turn of the century, there have been few standards to guide the pioneers.
One of the great debates and just plain conundrums of subscriptions has been how to recognize revenue. If a subscriber pays monthly that’s pretty basic. But often vendors want to lock customers into multi-year contracts with annual invoicing. So a typical subscription might call for an annual invoice, recognized in monthly increments by the vendor with the unrecognized revenue sitting in a bank waiting to be dinged. But that’s not the only possibility, in fact there are probably as many ways to recognize revenue as there are vendors and until ASC 606 and IFRS 15 came along, there was no authority to say which was better.
As you can imagine, a world without ASC 606, “Revenue From Contracts With Customers,” could lead to chaos especially given the metrics that the industry has auditioned and used over the years. Annual Recurring Revenue, Monthly Recurring Revenue, Unbilled Revenue, Deferred Revenue all have specific meanings but if your company doesn’t use one or more of these metrics it can become very difficult for financial analysts to make comparisons with other companies. Without comparisons and standards it’s harder to attract investment and to report to shareholders.
So 17 years into the subscription economy, after most of the software has been built and refined, we finally have standards for revenue recognition and that’s a good thing. You might quibble that this should have been done sooner but I’d disagree because in an emerging market it’s hard to know what will have staying power and what will be gone next week. So the standards come along at a good time.
Less wonderful is that the standards would like to be taken seriously beginning with annual reporting periods starting after December 15, 2018, just around the corner. Yes, we’ve seen this coming since 2014 and no, most of us didn’t do anything about it. Truthfully, did you even know about ASC 606 or IFRS 15 before reading this?
Now we have before us a perfect accounting storm the likes of which have not been seen since the late 1990’s when businesses en mass took on the four digit date format. Back in those good old days, people worked day and night trying to rip and replace financial systems to meet deadlines. Many of those people are managers today and they’re in no hurry to repeat the ordeal and fortunately they don’t have to.
Several ERP/accounting software vendors are advertising their ASC 606 capabilities, which might undersell the problem. More than simply having a way to recognize revenue from subscriptions it’s also critical to first have the ability to invoice and bill subscriptions as subscriptions rather than as some special case of a product. So the ASC 606 and IFRS 15 standards are really about an end-to-end process starting with invoicing and ending with revenue recognition. In between there’s a lot of change management to deal with as well.
So this is a big deal for subscription companies as well as those that bundle subscriptions with traditional products and services. But according to PwC http://www.pwc.com/us/revrecsurvey most companies are not prepared for dealing with the new standards. Furthermore, this change to accounting rules could be as profound as the four-digit date change.
Into all this Zuora, Inc. a leading provider of accounting and billing software for subscription economy companies, has launched an effort to manage the entire process. On Wednesday Zuora announced its intent to acquire Leeyo a leading provider of revenue recognition software. Over the last three years the companies have worked at numerous customer engagements providing customers with that end-to-end order-to-cash support that subscription companies all need.
Leeyo RevPro will become part of the Zuora product set as Zuora RevPro and Leeyo will become a division of Zuora. Since the companies have worked together to deliver this integrated solution for over three years, delivery of the combined system should be unexciting. However, as a separate division of Zuora, Leeyo will still have the ability to sell its products and services independently and that might be exciting.
The opportunity is sizeable. Starting with an assumption that almost every subscription vendor will need some form of solution to help comply with the new regulations, this merger is well timed. MGI Research estimates that the total addressable market (TAM) for what it calls Agile Monetization Platform software is over $100 billion between now and 2020.
Zuora and Leeyo expect the deal to close shortly.