With the adoption of Accounting Standards Codification (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.
Adoption Method
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.
Disclosure Examples
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.
Adoption of the standard resulted in…a reduction of unearned revenue, driven by the upfront recognition of license revenue from Windows 10 and certain multi-year commercial software subscriptions. Microsoft does not disclose the extent to which this reduction in unearned revenue is split between the $15.3 billion increase to stockholders’ equity (which reflects the cumulative effect of the standard) and the $6.6 billion increase in 2017 revenue; nevertheless, Microsoft’s side-by-side comparison of account balances before and after the new standard provides valuable information to financial statement users. The most significant impact of ASC 606 on our historical financial information relates to the timing of revenue…Under ASC 606, the requirement to have VSOE (vendor specific objective evidence) for undelivered elements was eliminated and we now recognize revenue for such software licenses upon transfer of control to the customer. Like Microsoft, Nutanix provided tables to show the effect of the standard on contracts in comparative reporting years: Of the early adopters of ASC 606 that selected the modified retrospective method, many disclosed that the new standard had an immaterial effect on their financial statements (see Note 3 in Ford Motor Company’s 10-K and Note 2 in UnitedHealth Group’s 10-K). Such entities justifiably disclosed fewer details regarding the impact of ASC 606. For example, in Alphabet’s 10-K for the year ended December 31, 2017, the company provided only the following disclosure regarding the impact of adopting ASC 606: We recorded a net reduction to opening retained earnings of $15 million, net of tax, as of January 1, 2017 due to the cumulative impact of adopting Topic 606, with the impact primarily related to our non-advertising revenues. The impact to revenues as a result of applying Topic 606 was an increase of $34 million for the twelve months ended December 31, 2017. The $34 million increase in revenues and $15 million reduction in retained earnings represent only 0.03 percent and 0.01 percent of total revenues and retained earnings, respectively. Although stakeholders are unable to determine the impact of ASC 606 on deferred revenue, this disclosure clarifies that any adjustment (and possibility of lost revenue) is immaterial. The company has recorded a cumulative effect adjustment to decrease retained earnings by $339 million as of January 1, 2018 as well as the following cumulative effect adjustments: The decrease in retained earnings primarily resulted from a change in the manner in which the company determines the unit of account for its projects (i.e., performance obligations). Under the previous guidance, the company typically segmented revenue and margin recognition between the engineering and construction phases of its contracts. Upon adoption of ASC Topic 606, engineering and construction contracts are generally accounted for as a single unit of account (a single performance obligation), resulting in a more constant recognition of revenue and margin over the term of the contract. In addition to disclosing these cumulative adjustments, Fluor also provided tables very similar to those prepared by Microsoft and Nutanix. These tables showed the current-year impact of ASC 606 on income statement, balance sheet, and statement of cash flow accounts. By including this information, Fluor elevated the level of disclosure provided by the modified retrospective method to that of the full retrospective method. Furthermore, this disclosure enables financial statement users to infer that Fluor likely lost little if any revenue, since lost revenue arises when deferred revenue decreases, and Fluor disclosed that contract liabilities increased by $357 million. When transitioning to ASC 606, entities may lose revenue when retained earnings is directly adjusted for changes to deferred revenue. Public entities that adopted using the full retrospective method minimized the impact of lost revenue and generally provided more comparative information to stakeholders. Private entities that are currently adopting ASC 606 may wish to evaluate the impact of lost revenue not only on their financial statements, but also on year-end employee compensation and commissions. For more information on which transition method may be best for your company, please see Transition Dates and Methods.Example 1: Microsoft - Full Retrospective Method
Example 1: Microsoft – Full Retrospective Method
In its 10-K for the fiscal year ended June 30, 2018, Microsoft adopted ASC 606 using the full retrospective method. To show the direct impact of ASC 606, Microsoft provided the following tables, which disclose the change in the affected income statement and balance sheet accounts for comparable reporting periods:
Microsoft’s tables, combined with related disclosure notes, are especially useful because they explain why and to what extent account balances changed as a result of the new standard. For example, the table above shows that unearned revenue decreased by $17.8 billion; in addition, Microsoft disclosed the following:Example 2: Nutanix - Full Retrospective Method
Example 2: Nutanix – Full Retrospective Method
Nutanix is another company that adopted ASC 606 using the full retrospective method. As a software company, Nutanix was able to recognize revenue much earlier under the new standard, which resulted in significant adjustments to deferred revenue. In Note 3 of its 10-K for the fiscal year ended July 31, 2018, Nutanix explained these changes:
With these tables and other disclosures, financial statement users can easily see the impact of adopting ASC 606 on deferred revenue for each year.Example 3: Alphabet - Modified Retrospective Method
Example 3: Alphabet – Modified Retrospective Method
Example 4: Fluor - Modified Retrospective Method
Example 4: Fluor – Modified Retrospective Method
For the construction company Fluor, adopting ASC 606 caused significant adjustments to many account balances; nevertheless, Fluor adopted using the simpler modified retrospective method. In Note 3 of its 10-K for the year ended December 31, 2018, Fluor disclosed detailed information regarding the impact of the new standard:
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