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Software – Bridging the GAAP to ASC 606

Jefferies Financial Group | December 20, 2018| 1 min. read

Jefferies' report -- which can be downloaded by entering your information in the form below -- serves as a primer on how the new accounting standards (collectively referred to as ASC 606) apply to Software companies. ASC 606 will generally tend to inflate revenue and profit, though cash flow will largely remain consistent. This will further solidify cash flow as the foundation for valuation in public companies. 

Overall Comments. Most companies have already adopted ASC 606, but its far reaching implications are just beginning to be ascertained by investors.  Jefferies believes the new standard(s) likely achieves its primary purpose of providing a framework across entities, geographies, and industries, but it sometimes allows for more aggressive accounting practices and results in increased opacity. As a new set of standards, they expect ASC 606 application to evolve into steady-state best practices over time.

Generally Greater Near-Term Revenue for On Premise Subscription Models. Little to no effect on perpetual license, maintenance, SaaS, or professional services (though caveats apply).  They expect little effect on revenue for those yet to adopt or report in accordance with the new standard.

Inflated Profit. Higher revenue and required amortization of sales commissions over a longer duration will inflate operating margins relative to ASC 605.  The Rule of 40 becomes less relevant in this context as a rule of thumb for the balance between growth and profitability

Consistent Cash Flow will generally allow comparability across history spanning both ASC 605 and 606, though it will materially pull forward revenue on the balance sheet for some companies, also pulling forward profit and cash taxes, having a negative effect on near term cash flow. 

Backlog, Billings, Bookings, New Subscription ACV. Other Implications. ASC 606 may yield a modestly more accurate estimate of New Subscription ACV. The new disclosure of total backlog will enable a more accurate estimate of total bookings, but total bookings in and of itself is not very helpful and can be very misleading without granular duration information, which is not likely to be disclosed. Billings, which was used as a proxy for bookings under ASC 605, is now less relevant as such, but can still be calculated with a modified relationship under ASC 606.

Other Implications. ASC 606 will require less conservative channel sales recognition on a sell-to vs sell-through basis, opening the door for undesirable practices, such as “stuffing the channel.” It may also result in the appearance of declining revenue after the first year of multi-year on premise subscription contracts.

Valuation - Cash Flow Remains King. ASC 606 will have little or no impact on free cash flow in most instances, therefore keeping true the most important metric in valuing Software stocks, in Jefferies' opinion. Recurring revenue multiples also remain true under ASC 606, but require incremental granular information for on premise subscription models.

Download Jefferies’ Report