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New seasonal swings in revenue due to a change in accounting standards could distort a key performance metric used to value software and technology companies.
The rules, which companies adopted this year, generally require revenue to be recognized when a product is delivered to customers. For technology companies, that timing results in different accounting treatments based on how customers access the product.
The timing of expensing direct costs like sales commissions—a key expense for software companies—also changed under the new standard.
The resulting revenue stream is “going to be a bit lumpy,” said Stacy Dow, a partner and national leader of the technical accounting consulting group at RSM US LLP.
Advanced Micro Devices Inc., for example, has said it expects higher sales in the second and third quarters for certain game console products.
Peaks and valleys in revenue could warp a key income statement metric: earnings before interest, taxes, depreciation, and amortization (EBITDA), Dow said. And that ultimately could change the perception of a company’s value, she said.
Some analysts, including John DiFucci, managing director and senior research analyst for software with Jefferies Group LLC, say that cash flow becomes a better measure of a company’s performance and financial health.
The accounting changes don’t affect cash, which companies need to sustain and grow their business, or the rate of revenue growth. Instead, the rules benefit companies by improving their operating margins, and ultimately earnings per share, DiFucci told Bloomberg Tax.
“You can’t buy bread with EPS; you need cash,” DiFucci said.
The new standard replaces industry-specific rules and generally requires revenue to be recognized sooner. But differences exist depending on the business model and the mix of products.
Revenue from cloud-based services would continue to be recorded over the term of the contract, Dow said.
But revenue from licensed products, such as traditional software run on a customer’s own servers and computers, is now recognized upfront. Maintenance or support services revenue, however, will be spread out over the life of a contract or project, Dow said.
“On the revenue side, there’s not as much change for software-as-a-service companies,” as there is for tech companies that sell on-premise technologies, she said.
Companies such as CA Inc. and Splunk Inc. that sell subscriptions for on-premise technology have seen some of the biggest adjustments from the revenue changes, DiFucci said.
Splunk’s accumulated deficit shrank by $324 million when it adopted the new standard as of February, according to the company’s restated fiscal year 2018 financial information. The changes resulted in a one-time $2.1 billion boost to retained earnings for CA, which provides software tools used to manage networks and enterprise systems.
Part of that swing for CA represented several years of deferred revenue that was recognized, DiFucci said.
Companies will have to pay taxes on those one-time earnings adjustments. The multibillion-dollar boost to retained earnings for CA resulted in a tax bill of about $280 million and shifted millions more to the company’s deferred taxes, according to company financial reports.
Revenue changes were obvious for companies with a big licensing component like CA, but others also have reported large adjustments.
Few companies have suggested that the accounting changes could be significant enough that it might change their investing strategies, said Mandeep Singh, a senior technology analyst for Bloomberg Intelligence.
“No one will say that it’s affected them in a big way,” Singh told Bloomberg Tax.
Cisco Systems Inc. expects a $2.3 billion shift to retained earnings when it adopts the new revenue recognition rules this quarter, the company said in September.
Cloud-based provider Salesforce.com Inc. reported a shift of $972 million to retained earnings when it adopted the standard on Feb. 1.
Singh called such one-time swings in revenue a temporary gain. “Once it’s done, the clock is reset.”
Investors have largely ignored the massive adjustments reported by some companies. They understand they will have better numbers to compare in successive quarters, he said.
Meanwhile, the accounting rule changes helped blunt Intelsat S.A.’s earnings decline. Instead of a projected 4 percent drop in the second quarter, earnings ticked up 1 percent for the satellite services company, said Stephen Flynn, a telecom and media analyst for Bloomberg Intelligence.
The accounting changes improved the company’s performance by boosting revenue and EBITDA. And the news rules are also expected to help the fixed-satellite company see an annual revenue increase of 1 to 2 percent—significant for a company that hasn’t seen an annual increase since 2012, Flynn sad.
The change in sales commission accounting benefits cloud-based companies, which can now defer commissions, an option not available under the previous rules, and improve their operating margins, Singh said.
Instead of expensing commissions upon signing a contract, companies now will capitalize those costs, offsetting future revenue, Dow said.
Companies could stretch out those costs over three to seven years, she said.
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