With the adoption of ASC 606, many entities were required to adjust deferred revenue because of changes in the timing of revenue recognition. In some cases, this adjustment resulted in revenue never being recognized in the income statement (i.e., “lost revenue”). This article explains the link between adoption methods and lost revenue, the various impacts of lost revenue, and how entities have chosen to disclose the impact of lost revenue under each adoption method. For private companies and nonprofits that are currently adopting ASC 606, this article provides a useful guide to help navigate the various impacts of ASC 606 adoption on deferred revenue.
The extent to which lost revenue has affected a given entity is linked to whether that entity adopted ASC 606 using the full retrospective method or the modified retrospective method. Many entities were initially drawn to the modified retrospective method because it requires only an adjustment to equity for the cumulative effect of applying the new standard. As such, account balances in comparative financial statements remain unchanged. This simplification, however, causes all deferred revenue adjustments to be reclassified directly to retained earnings in the current period rather than recognized as revenue in the period stipulated by ASC 606. Consequently, entities with large changes to deferred revenue have lost significant amounts of revenue.
Some entities have minimized the impact of lost revenue by applying the full retrospective method rather than the modified retrospective method. The full retrospective method requires entities to present all prior reporting periods as if ASC 606 had always been in effect. Therefore, the retained earnings account of the earliest balance sheet presented must be adjusted to reflect the cumulative effect of the standard, and any impact to the revenue of subsequent income statements is spread over multiple years rather than recognized entirely in the current reporting period.
Impact of Lost Revenue
Because bonuses, commissions, and share-based compensation are often contingent on year-end revenue, many entities have been forced to evaluate the impact of lost revenue on both financial reporting numbers and payout amounts to employees. Public entities have not disclosed how such employee-relation issues have been resolved, but private entities that are currently adopting ASC 606 should evaluate whether lost revenue will impact their calculation of compensation and commissions to avoid surprising unsuspecting employees.
In dealing with changes to financial reporting numbers, entities that chose the full retrospective generally provided more information and greater comparability to stakeholders. However, despite the full retrospective method’s advantages from a comparability standpoint, the modified retrospective method was often selected due to its simplicity. For example, whereas the full retrospective method required entities to reevaluate every contract from both the current and comparable reporting periods, the modified retrospective method required evaluating only those contracts that impacted the current period. The complexity of the full retrospective method was increased by the need to restate more contract costs, such as commissions, which are often amortized over the total expected benefit period. For more information on contract costs, see the RevenueHub article “Incremental Costs of Obtaining a Contract.”
To compensate for the modified retrospective method’s lack of information and comparability, some entities have provided more robust footnote disclosures. In many cases, the scope of these supplemental disclosures appears to correspond to the significance of the new standard’s impact upon adoption, as shown in the next section.
The following examples are taken directly from 10-K filings to illustrate how four public entities have disclosed the impact of ASC 606 on deferred revenue. These entities used the following adoption methods:
- Microsoft – Full retrospective method
- Nutanix – Full retrospective method
- Alphabet – Modified retrospective method
- Fluor – Modified retrospective method
In using the full retrospective method, Microsoft and Nutanix provided more detailed information to stakeholders, as evidenced by their disclosures below. Alphabet and Fluor adopted using the modified retrospective method, which generally provides less information to stakeholders. As expected, Alphabet’s disclosure is relatively simple and contains little additional information. In contrast, Fluor was significantly affected by the new standard and therefore provided a much more detailed footnote with a level of information comparable to that of Microsoft and Nutanix.
The graphic found at the beginning of each example is modified from a similar graphic found in KPMG’s Handbook on revenue recognition.