An Accounting Tale from the Crypt: How Applying New Revenue Rules Went Awry

A story about how one software giant lost $3 million after applying the new revenue recognition rules surfaced during the June 26 Financial Executive International conference, which focused on implementing Topic 606, Revenue from Contracts with Customers.

The story was raised as a cautionary tale-particularly to software firms-so that they would look at their contracts and balances when applying the new rules.

Audience members hadn’t heard of it and were keen to listen.

As told by panelist Seamus Moran, senior director at Oracle Corp., $3 million of Microsoft’s revenue went down the toilet when they applied the revenue standard.

Not literally, of course, but the incident occurred during a test run implemented  by the Securities and Exchange Commission and the Financial Accounting Standards Board in the fall of 2013.

A number of big companies did a pseudo-close of their books, and Microsoft was one of them. 

Rules Left Them Hanging.

At that time the software giant had recently launched Minecraft—a software game.  At first it released 12 episodes and then later that March the other six-totaling 18.

Microsoft sold the product at retailers Walmart and Best Buy, generating about $4 million in revenue. Microsoft therefore had the $4 million in the bank, but software rules don’t allow the recognition of that revenue until the rest of the games were shipped. 

So they closed their 2013 balance sheet with $4 million declared revenue and nothing in their Profit & Loss column. Then they applied the new rules but nothing in the rules say ‘recognize the performance obligations to six games’ they hadn’t shipped. They therefore valued that performance obligation at being about $3 million with $1 million left for the games they hadn’t shipped.  

Where did the $3 Turn up?

To shorten the story: under the new rules they had $1 million worth of performance obligation liability instead of $4 million worth of deferred revenue liability.  

Then they had the question ‘where did that $3 million turn up’? “It tuned up in the fine print as a restatement, or it turned up in the fine print as a disclosure item the following year depending on how they chose to do the external reporting,” said Moran, “which is to say it didn’t turn up at all on the P&L.”  

“In essence $3 million went down the toilet,” he said.

Luckily it was all a bad dream because the standard isn’t yet applicable, and they could book the normal way under current rules. 

To learn from that potential pitfall, software companies should look at the contracts they have today, because they could end up facing a similar fact pattern, the discussions indicated. They should be looking at their balances and contracts, said Moran.

Applying Rules Significant Transformation to Business.

In fact, in looking at the new revenue accounting standard, companies should view it as a significant transformation to their business, said another panelist, Steven Hobbs, managing director of Protiviti Inc.

It has all those pieces of transformation: planning; GAAP analysis; thinking about what it means for the organization, how much it’s going to cost, who is going to be responsible, he said.

It’s important that companies plan for and make their assessments now especially since it’s going to be their first time applying a principles-based standard, the discussions indicated.

“This is the first principles-based standard that’s come into the U.S. since 1927,” said Hobbs. “That’s a long time ago,” he said.

Not only is it a first time through for U.S. preparers, said Hobbs, it’s a first time through for the audit committee; for CFOs; for the CEO; and for external auditors. 

“There’s going to be a lot of companies who stumble out of the block because they’re not going to appropriately plan,” he said.

Don’t Slow Down.

Another panelist, Eloise Wagner, a partner at Ernst & Young LLP, said she noticed a slowing down of companies doing their accounting diagnostic stemming from FASB’s consideration of deferring the effective date.

“Or maybe companies who were on the verge of starting their accounting diagnostic said ‘let’s wait and see’, which obviously we would advise against,” said Wagner.  “If the board is giving extra time it’s because you need it,” she said.

Interesting tidbits other panelists highlighted is the seeming disconnect within firms at a management level.  One panelist said a lot of organizations look at implementation of the rules as an accounting and finance exercise, with a mindset of ‘so you folks go do it in a corner and when you’ve got it figured out let us know’.  

“They’re going to find out it’s more than that,” the panelist said.

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