Most product management organizations are primarily focused on the evolution of their products. They concentrate on understanding the market’s needs and translating them into user stories and backlog items so that the Development team can build and launch new and improved versions of their products. Over the past few years the industry has shifted from the legacy approach of software licensing and maintenance fees to subscription based pricing. At the same time the accounting standards, such as those promulgated by Financial Accounting Standard’s Board (FASB) and International Accounting Standards Board (IASB), have evolved as well. Topics like ASC 606 Revenue from Contracts with Customers dealing with revenue recognition and ASC 340 Other Assets and Deferred Costs have fundamentally changed how revenues and expenses are treated from an accounting perspective. These changes have an impact on how the financial performance of products are judged by investors, analysts, and your own executives. Product managers should have basic financial literacy, but the implications of these and other new accounting policies will exceed most product manager’s capabilities. Instead product managers should become best friends with the Finance organization who can help them navigate this new, complex world.
It All Starts with ASC 606: Revenue from Contracts with Customers
ASC 606 is the new revenue recognition standard that affects all businesses that enter into contracts with customers to transfer goods or services – public, private and non-profit entities. Both public and privately held companies should be ASC 606 compliant now. In the past, revenue recognition standards differed between the generally accepted accounting principles (GAAP) in the United States and the global provisions set by the International Financial Reporting Standards (IFRS). It was universally acknowledged that these rules needed to evolve due to varying ways they were being applied and loopholes they created, so the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) launched a joint initiative to better align these standard practices globally, which resulted in the 2014 publication of the new “Topic ASC 606: Revenue from Contracts with Customers”. ASC606 started being implemented in 2016, by 2020 al companies had to comply
Basic revenue recognition is similar, but now there are more complicated requirements for handling items like Post Contract Support (PCS), setup/customization fees, variable considerations like Service Level Agreement bonuses and penalties. Check out this excellent primer from PWC on the differences between GAAP reporting and ASC 606 reporting.
On the expense side, Incremental costs of obtaining a contract (commissions, etc.) ae handled differently than under GAAP/IFRS. Commission expenses can continue to be recognized when incurred if the determined amortization period is one year or less. Commission expenses must be amortized for individual reps over the anticipated life of the customer if the contract is longer than one year, but any indirect or rolled commissions for supervisors/managers will continue to be recognized immediately regardless of the determined contract term length. Every time the existing rep or other rep sells to the customer again, you must evaluate if that extends the life of the customer or servicing existing life expectancy. For each additional commission calculated and paid, you must be able to quantify the impact their action did to further that customer for commission expense amortization considerations.
The practical implementation of ASC 606 results in higher profitability for most products due to the longer term amortization of incremental costs of obtaining a contract. Revenue is generally not affected since under GAAP and IFRS revenue recognition was tied to when the service was delivered. In the case of prepays, like a prepaid annual subscription, the cash payment was recorded as deferred revenue and then recognized month by month.
ASC 606 is a complicated topic that I usually beyond the scope of most product managers training. They should work closely with their finance team to understand how ASC 606 has impacted the P&L of their products.
Pro Forma is as Good as it Gets
If an enterprise has more than one product line, product managers will most likely have access to only pro forma P&Ls. Most enterprises can track revenue at a product line level, but face significant challenges on the expense side. Some expenses, like commissions and developer headcount specifically associated with a product, are directly tied to a specific product. Many expenses, like customer support, finance, and HR support many products. As a result the finance team must allocate these expenses amongst the various products. There are many ways to perform the allocations, but it is an exercise in pro forma reporting.
Product managers should be aware of how the finance team is allocating expense to their product lines. Under/over allocation impacts the profitability of a product. This in turn may impact how executives decide to invest or allocate resources to a specific product line.
Product Management Metrics Validation
Product management teams live and die by the metrics that describe the performance of their products. As noted in Product Manager Metrics: Process is as Important as Formulas:
All parts of the organization that are impacted by a metric must share a common definition of what the metric is, how it will be calculated, and how the results will be interpreted. Marketing, Sales, and Finance may have different views on how LTV could be calculated, but these views have to be reconciled and one definition agreed to. Otherwise the organization whose views were not addressed will ignore or dismiss the metric. The consequences of not taking corrective actions could be serious.
Finance teams are generally responsible for the production of metric reports. They are seen as the ‘single point of truth’. Product managers need to work closely with the finance team to design and execute an effective metrics program.
Deferred revenue is a liability on a company’s balance sheet that represents a prepayment by its customers for goods or services that have yet to be delivered. Deferred revenue is recognized as earned revenue on the income statement as the good or service is delivered to the customer. If the good or service is not delivered as planned, the company may owe the money back to its customer. A common scenario in the SaaS market is for vendors to require annual prepaid contracts (like Salesforce does). In such cases, when a customer payment is received it is recorded as deferred revenue. Each month during the contract term a portion of the balance is recognized as revenue.
A challenge for product managers is that enterprises sometimes ‘repurpose’ the cash received as deferred revenue. The cash should be used to deliver the product or service over the life of the agreement. Some companies, especially those who are having cash flow challenges, often use the cash for other purposes. If unchecked, this can result in a situation where in the long term the company does not have the cash to pay the operating costs required to deliver the product or service.
Product managers should work with their finance team to understand the deferred revenue balances associated with their products and how the cash received from customers as deferred revenue is actually being used.
A somewhat esoteric topic that product managers should learn involves transfer pricing. Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. It is common for multi-entity corporations to be consolidated on a financial reporting basis; however, they may report each entity separately for tax purposes. As described by Investopedia:
When transfer pricing occurs, companies can manipulate profits of goods and services, in order to book higher profits in another country that may have a lower tax rate. In some cases, the transfer of goods and services from one country to another within an intracompany transaction can also allow a company to avoid tariffs on goods and services exchanged internationally. The international tax laws are regulated by the Organisation for Economic Cooperation and Development (OECD), and auditing firms within each international location audit the financial statements accordingly.
Product managers should be aware of how transfer pricing impacts the profitability of their products/services.
Goodwill impairment is an accounting charge that companies record when goodwill’s carrying value on financial statements exceeds its fair value. In accounting, goodwill is recorded after a company acquires assets and liabilities, and pays a price in excess of their identifiable net value.
When a company grows by acquisition, it often generates a lot of goodwill on their books. When an acquirer ‘overpays’ for an acquisition – in other words the acquisition cost significantly exceeds the fair value of the acquisition target’s assets, the difference is recorded as an asset on the balance sheet. Prior to 2001, goodwill had to be amortized (usually over 10 years) and reported on a company’s P&L. Now the entire amount stays on the balance sheet as an asset, but is subject to an annual test to see if it had become impaired. Goodwill impairment is an accounting charge that companies record when goodwill’s carrying value on financial statements exceeds its fair value. In accounting, goodwill is recorded after a company acquires assets and liabilities, and pays a price in excess of their identifiable net value.
If the goodwill associated with a product manager’s product lines is impaired, it will result in significantly lower product line profits. This in turn can impact how a product is perceived by executive management and result in lower or cancelled long term investment.
Gross Margin Requirements
Gross Margin is equal to net sales minus cost of goods sold (COGs). Many enterprises have standards or targets for gross margin that each product must meet. A former employee of mine who had moved into a senior product management position at a major worldwide provider of telecommunication equipment suddenly found himself out of a job when the gross margin of the products he managed fell below 75%. Part of the decline was due to rising headcount costs (health insurance, etc.) and another part was due to a series of goodwill impairments.
Product managers should be constantly aware of expected performance standards and how their products are performing against those standards. Again, close partnership with the finance team can ensure access to the required information in a timely manner.
Understanding and managing the finance aspects of a product line has become significantly more complex over the past few years. Most product managers do not possess the knowledge and skills that are required. Building effective relationships with their finance and administration peers can be very helpful for product managers. In some cases it ca make the difference between being employed or unemployed.
Also published on Medium.
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