Fastly Warns of Improper Accounting Due to Material Weakness in Internal Controls
Cloud company blames complex contracts for financial reporting errors which seems to conflict with prior correspondence with the SEC.
March 4, 2021
Fastly (FSLY), an edge cloud platform for processing, serving, and securing applications, admits it has lacked the appropriate people and systems to account for complex contracts which has resulted in the inaccurate application of GAAP accounting principles. In its 2020 10-K, Fastly disclosed the matter is still not fully resolved:

“We and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting for the years ended December 31, 2019 and 2018, which remains partially unremediated for the year ended December 31, 2020.”

The language suggests that material weaknesses for 2018 and 2019 have been fixed. This suggests substantial progress as Fastly hadn’t yet fixed three years of financial reporting deficiencies as of the prior annual report. In its 2019 10-K, the company disclosed material weaknesses date back to 2017 and that:

“...we are still in the process of implementing, documenting and testing these processes, procedures and controls. Additional time is required to complete implementation...the material weaknesses cannot be considered remediated until the applicable remedial controls operate for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively.”

If Fastly has caught up, correcting three years of financial reporting issues, it doesn’t necessarily mean investors can let their guards down. Besides the unremediated material weaknesses for 2020, Fastly blamed its financial reporting issues on a lack of sufficient personnel with the knowledge to properly apply GAAP accounting principles to complex transactions. The claim is problematic as it seems to conflict with statements Fastly made to the SEC in 2019, which suggested the company’s contracts are relatively clearcut.

Prior to its initial public offering (IPO) in May 2019, the SEC sent Fastly a letter asking the company to clarify several matters, including two related to revenue recognition. In response, Fastly told the SEC it saw no reason for additional disaggregation of revenue disclosures beyond those it already provided like geography and customer size (enterprise vs. non-enterprise customers).

Fastly seemed to suggest to the SEC that the accounting for both enterprise and smaller customers is straightforward:

“...when providing these products and services, there are no identifiable differences as to how the products and services are provided based on differing geographic regions, types of customer, customer market or sales channel. Additionally, there is no difference in expected cash flow or revenue recognition by customer based on geographic regions, type of customer, customer market or sales channel.”

Nowhere does Fastly mention complexity as an issue. Nor is there any ambiguity as it pertains to contract terms or expectations.

The majority of contracts include a minimum commit price, after which customers are charged based on the additional services used. Fastly recognizes additional revenue for any services provided above the minimum commit price. In its 2020 10-K, Fastly suggests revenue recognition is black and white:

“Because our typical contracts represent distinct services delivered over time with the same pattern of transfer to the customer, usage-based consideration primarily related to actual consumption over the minimum commit levels is allocated to the period to which it relates.”

Revenue recognition appears to be a monthly rinse-and-repeat exercise in accounting. Usage charges reset each month, only apply within the current month, and the customer does not receive a discount in any one month based on usage in other months. There is no discount carryover to account for.

Though undoubtedly more complicated than a subscription billed annually or ratably in equal installments, Fastly’s argument that it was overwhelmed by the complexity of usage-based customer contracts for the past four years seems inconsistent with its statements to the SEC and its footnotes in the latest 10-K.

More recently, Fastly began offering services for which the billing appears even more straightforward:

-Professional services— think implementation— are billed as a flat one-time or recurring fee
-Subscriptions to a security web application and application programming interface at a fixed rate

Even if you disagree with our conclusion that Fastly’s customer contracts aren’t overly complex, you may be surprised at the reason Fastly’s auditor expressed an adverse opinion on the company's internal control over financial reporting.

In the footnotes, Fastly makes a revelation some might perceive as unbecoming of a high-tech, Infrastructure-as-a-Services (IaaS) company:

“The processing and recording of certain revenue requires a manual process, and therefore we use a complex set of procedures to generate complete and accurate data to record its revenue transactions.”

Fastly’s auditor, Deloitte, identified the manual processing of revenue as a critical audit matter due to the volume Fastly processes. Deloitte doesn’t break out what percentage of Fastly’s $290 million in revenue was processed manually. In explaining how it handled the matter, Deloitte suggests it checked Fastly’s work by recalculating a sample of Fastly’s manually processed revenue:

“We compared our recalculation of manually processed revenue transactions to the Company’s recorded revenue and evaluated any differences.”

DuDil contacted Fastly for more information. Specifically, we asked whether differences exist between Fastly and Deloitte’s calculations. If so, we requested that Fastly quantify the differences. We’ve also asked Fastly how using Deloitte’s calculations might impact 2020 revenue.

In response, Fastly’s CFO Adriel Lares told us no differences between its calculations and Deloitte’s were reported back to Fastly. This presumes, Lares adds, that if there were any differences they are not material.

“What this relates to is for some customers we have custom billing that requires us to calculate their bill outside of our billing system,” Lares says. “We have a process to verify the accuracy.”
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