The channel has been obsessed with compliance efforts around the EU's General Data Privacy Regulation (GDPR), but there's another major change coming down the pike. Earlier this year, Financial Accounting Standards Board (FASB) issued ASC 606, the biggest corporate finance compliance change since Sarbanes-Oxley rocked accounting departments nationwide more than 15 years ago. Is your business ready to comply?
ASC 606 is a much-needed, timely overhaul to the way businesses recognize revenue. Current accounting standards were created for a cash-based economy, which has worked well for centuries. But in a digital, subscription-based economy, customers consume and pay for products and services on an as-you-go basis. Because the subscription economy became widespread so quickly, each industry and sector created its own practices around when recurring revenue can be recorded and recognized. Software-as-a-service (SaaS) providers, for instance, played by different rules than a data center renting server real estate.
What Is Revenue Recognition?
When a managed service provider (MSP) makes a sale, it has to be recorded in the company’s financials. But to date, there have been no hard and fast rules around when that revenue is formally recognized in the books, whether it’s upon making the sale, collecting payment or fulfilling the contractual obligation by performing the service or providing the product. With recurring revenue, things get trickier. If an MSP sells a one-year contract to provide services on a monthly basis, does it record that revenue as one lump sum that equals the total sale amount? Does it record it monthly or quarterly? And what if the service package is comprised of several offerings all rolled into one, like desktop as a service, backup and disaster recovery (BDR), or managed firewalls?
Before ASC 606, there was no regulation that spanned industries and business models that answered these questions. This was the challenge the FASB set out to solve with the new regulation, and it’s a massive undertaking for business as a whole and a huge headache for service providers as they work toward becoming compliant by the December deadline.
What It Means for the Channel
A PwC report predicted that “products and services is expected to be one of the areas most impacted by the new standards.” There are big changes with multiple ramifications in the way MSPs sell and service their offerings.
Currently, elements of a contract can’t be recognized until they are delivered, which results in revenue being formally recorded over the life of the contract. ASC 606 deletes this Vendor Specific Objective Evidence (VSOE) requirement so partners can recognize a much bigger portion of revenue at the initial sale, even if it entails a long-term contract.
How does this play out in practice? That isn’t exactly easy to define. The kicker to ASC 606 is its ambiguity. It’s a judgement-based regulation, not a rules-based one. There's a lot of room for interpretation, which means there are also opportunities for inadvertent error and deliberate manipulation. Not only is the definition of a contract vague, but so is the actual product or service being sold. If an MSP sells a BDR offering, it might include a threat-management component. If that element isn’t specifically outlined in the contract, the MSP has to make a judgment call if the promised service (BDR) and the implied expectation (threat management) should be recognized separately. If they are, it’s up to the MSP to decide how much revenue to allocate to each service if they’re sold as a bundled package.
The crux of ASC 606 is that it doesn’t only impact a company’s finance team. Every line of business has the potential of being affected.
“We expect to implement all of our changes early in the [fourth quarter], to be compliant with the deadline,” said Tom Clancy, CEO of MSP Valiant Technology. “Hopefully it doesn’t involve much beyond a comp-plan change for our sales teams, and accounting/revenue recognition changes on the back end, but I’ll hesitate to commit to that being the only mechanical changes until [my CPA] tells me it is so.”
But the changes, while primarily impacting accounting and business development, have a ripple effect that touches every department. The new regulation, for instance, requires a significantly higher number of reported data points – too many for most companies to keep up with manually – so these organizations will probably need to have some sort of front-end system automation to eliminate silos between departments. MSPs know the value of an enterprise resource planning (ERP) or professional services automation (PSA) system — as well as how painful such an implementation can be to both customer and provider. Partners that don’t yet have such a system or who have customers still operating on disparate platforms should brace themselves for the significant overhaul this kind of automation requires.
On the sales side, contractual language has always been important for revenue recognition, but under ASC 606, the definition of contract includes verbal deals, side agreements or even a pattern of doing business with a client. Finance and sales, therefore, must work closely together to ensure the deals sales are landing are structured in such a way that they comply with the new standard. Clearly, this will have an impact on sales commissions, too. The ramifications are far-reaching.
For partners looking to be acquired, ASC 606 is a huge deal. That's because it allows for revenue to be recognized when the contracts begin, which can lead to impressive sales figures and deferred revenue, both of which are attractive to investors. But that deferred revenue will be lower and more difficult to forecast, leading to a volatile cash flow. It’s hard to put a valuation number on a company that can’t confidently predict future revenue.
Are Partners Prepared?
The effective date for public companies was annual reporting periods (including interim reporting periods within those periods) beginning after Dec. 15, 2017. Privately held organizations got a little more of a grace period, with a deadline of Dec. 15, 2018. As we saw with GDPR, many partners feel ASC 606, despite the significant changes it will introduce, don’t impact them. Others are just now starting preparations, hoping they’ll be compliant by the Dec. 15 deadline.
Lauchie Johnston, CEO of MSP LMJ Consulting, hasn't seen an impact on her business or service offerings yet, and "only sees it on the accounting system side for clients." Holly Dowden of MSP Ntiva says her team is ahead of the ball, explaining that "the changes to ASC 606 don’t materially impact how Ntiva recognizes revenue, due to the way our contracts are structured."
But many partners we spoke with freely admit they don't know what they don't know, and are leaving the nuts and bolts up to their financial professionals.
"My accountant...is doing a great job of keeping the intensity in his own lane, and keeping me out of it, until it becomes time to implement policy and legal shifts," said Clancy. "Generally speaking, this topic has been a bit over my head, which is why I have an accountant, instead of a having a career as an accountant."