Why ASC 606 is the biggest leadership challenge for CIOs in 2018

IT budgets tied to corporate revenue must account for a fundamental change in revenue recognition. For CIOs to be true business leaders, they must guide their organizations through this change that affects budgets, forecasting, and demand planning.

ASC 606 is a new United States standard for revenue recognition (outside of the U.S., this standard has also been introduced as IFRS 15) that redefines when and how companies can define their revenue. This change potentially changes how a wide variety of deliverables can be recognized from a revenue perspective, including sales involving deferred or delayed delivery, digital services, or bundles of assets and services. This may include software licenses, gift cards, or any initial sale with a service, subscription, or maintenance component. For U.S.-based public businesses, certain non-profits, and certain employee benefit plans, the effective date for enacting ASC 606 is for annual reporting periods beginning after December 15, 2017. Companies are permitted to adopt this standard beginning after December 15, 2016 and a few companies have already done so including tech behemoth Microsoft. For all other organizations, the effective date is for annual reporting periods beginning after December 15, 2018.

ASC 606 is FASB's most recent take on revenue recognition which sought to clean up some of the accounting confusion associated with bundled services, delayed or deferred delivery, and situations where cash and delivery were not well aligned. In May 2014, FASB issued ASC 606, Revenue from Contracts with Customers, which defined revenue recognition standards based on the following 5 steps:

  • Step 1: Identify contracts with a specific customer.
  • Step 2: Identify performance obligations in the contract.
  • Step 3: Determine the transaction price.
  • Step 4: Allocate the transaction price to the performance obligations in the contract.
  • Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

Seems simple, right? If it were only so easy to implement, I wouldn't be spending so much time over the past 18 months in tracking the relative inaction that companies have taken in preparing for this substantial change...

The key change in this new standard is that companies must recognize revenue as they satisfy defined performance obligations. Previously, organizations would postpone revenue recognition until they were fully sure that revenue was recognized or spaced out revenue recognition based on the schedule of delivery rather than on weighting the contribution of each obligation. In practice, this standard has led to significant changes in how companies recognize software licenses, gift cards, and a variety of other deliverables where the company may be responsible for additional support over time or where the product may or may not be used. 

One of the key examples of this change is in Microsoft's recognition of Windows 10 OEM revenue. Previously, Microsoft spaced out recognition evenly over three years to represent the likely lifespan of Windows 10 on each computer. However, now that revenue has to be assigned to a "performance obligation," Microsoft has frontloaded the vast majority of Windows 10 revenue to the first year and assigned a small percentage of revenue to the second and third years to align with the automated updates, upgrades, and patches that will be delivered. This revenue change effectively accelerates the amount of revenue recognized upon delivery from 33% to 98%. This change does not change cash flow or payment terms in any way: it simply changes the definition of when revenue is recognized by the financial entity.

Why should CIOs care?

It is common for IT budgets to be benchmarked to a percentage of revenue. With this change, Amalgam notes that companies that need to redefine revenue for a specific asset, service, or bundle are typically defining performance obligations that end up frontloading revenue. This is a good news/bad news situation for CIOs. For 2018, this will likely mean that IT budgets will see a temporary boost associated with revenue increases, or at least they should if IT is supposed to be linked to the business. CIOs truly running IT as a business need to account for this change and plan accordingly in terms of aligning resources and capabilities. This may be a one-time windfall or a predictable increase depending on the nature of the company's revenues.

The flip side of this change is that some of these changes may result in unfunded mandates going forward. For instance, imagine that the majority of Windows 10 IT and developer support ends up being needed after the initial purchase. In this case, Microsoft's IT department will need to spend money that it may no longer have. Because of this, it is vital that CIOs prepare for this potential issue by seeing if their IT budgets and needs align to corporate revenue changes. If not, CIOs may need to either shift some of their existing revenue-based budget to future years or plan to change their budgets from an overall revenue-basis to a cash flow-basis, recurring-revenue basis, percentage of SG&A costs, or other basis that allows IT to be aligned with the true operations, support, and technical innovation needs of the business.

Key recommendations for CIO analysis of ASC 606:

1. Discuss performance obligation changes with your CFO

By doing so, CIOs can make sure that any potential changes are accurately defined and that they are priced based on the full "obligation" that the company has to deliver on each transaction. Once these changes are identified, work with the IT leadership to ensure that there are no significant gaps between proposed performance obligations and current IT resources. With only a couple of months left for public companies, this is your last chance to provide input on performance obligations and effort-based price allocation.

2. Identify significant revenue recognition changes that your company is discussing as well as any guidance that your company has provided to the market or to key investors

At this point, CIOs should be fully aware of any material changes to 2017 and 2018 revenue based both on legacy and new ASC 606 accounting methods. It is most likely that these accounting changes are resulting in an acceleration in revenue recognition. This is also an opportunity for CIOs to identify if they may be in store for additional budget in the new year. Claim it and use it OR ignore it and lose it.

3. Identify IT services associated with any revenue category where new "performance obligations" or "price allocations" have been defined

This is going to be a key challenge for future years. The front-loaded IT budget may lead to unfunded support requirements in the future, especially if the performance obligations for a contract have not fully taken IT demands into account. As mentioned in the theoretical Microsoft example, the rest of the business may be significantly underestimating the ongoing effort needed to support a recurring or "automated" service

4. Consider a change in how the IT budget is benchmarked or allocated if ASC 606 ends up misaligning revenue with IT

For IT to get its fair share, IT must be tied to the most relevant metric. If revenue metrics are not well-aligned to the future efforts of IT, it may be necessary to reconsider how IT is budgeted. Rather than tie to performance obligations that are defined by financial or sales obligations, it may make more sense to tie IT to renewal efforts, incoming cash flow, accounts, or other metrics that are better aligned with the true strategic value of IT. 

ASC 606 changes the definition of revenue and will wreak unexpected havoc on internal budgets across the planet. CIOs must prepare to be good business managers in the face of this financial shift to ensure business alignment and service quality. This is the CIO's chance to demonstrate a full understanding of the business and how IT services and responsibilities are aligned to the delivery obligations of the company as a whole. CIOs who pass this test of ASC 606 alignment will show their value as true executive leaders. Those who fail are at risk of either losing their jobs to more business-savvy individuals or failing their long-term responsibilities to their organizations as the IT organization ends up being poorly structured to support future obligations.

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