In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), for public business entities, certain not-for-profit entities, and certain employee benefit plans. The amendments become effective for public entities for annual reporting periods beginning after December 15, 2017.
In other words, the new revenue recognition standard is here, and it will significantly impact the software industry going forward. Is your organization ready?
The key to the new revenue recognition standard is understanding that it’s judgment based, not rules based. This not only allows more room for interpretation, but also for manipulation and even fraud. Companies need not only to understand the new revenue recognition standard, but also the role that internal controls will play in complying with this standard going forward.
Step 1: Identify the Contract With a Customer
A contract, which can be written or oral, is an agreement between two or more parties that creates enforceable rights and obligations. A contract can also be implied by a pattern and practice of doing business. A contract can also be created via side agreements, once again written or verbal.
Step 2: Identify the Performance Obligations in the Contract
A performance obligation is a promise to provide a good or service to a customer under a contract. Under this new standard, companies must determine if there is a valid expectation for such performance outside of this contractual promise. Both the expectation and promise must be distinct; this is a judgment call by the company.
Step 3: Determine the Transaction Price
This is the amount a company expects to receive in exchange for performance to a customer, excluding amounts collected on behalf of third parties. This prong will have the most judgment calls because there must be consideration of a plethora of variables such as discounts, rebates, refunds, incentives, and others. It can also include payment terms.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
Under this requirement, if a contract has more than one performance obligation, a company must allocate the transaction price to each performance obligation in a standalone selling price. There is no specified method to determine this standalone selling price, but determination must accurately represent what the company would charge.
Step 5: Recognize Revenue
An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. Goods or services are transferred when (or as) the customer obtains control of them. This means when the customer has direct use of the goods and all the benefits from the services.
Deloitte has said “the impact of the new standard on software entities may be greater than any other industry group.” A PwC report also predicted that “the accounting for software products and services is expected to be one of the areas most impacted by the new standards.” Moreover, there are questions about how well prepared some software firms are for this new standard, as the time for implementation is here. In an analysis of the new revenue recognition standard, Matt Kelly and Pranav Ghai noted, “Numerous firms say they plan to implement the standard by January 1, 2018—but still report that they are uncertain about its possible effect, or even what adoption method they will use.”
Perhaps the biggest change is the deletion of the requirement of Vendor Specific Objective Evidence (VSOE), which was used to determine elements of a contract that had not been delivered. In these instances, revenue from those elements could not be recognized, at least until they were delivered. This led to increments of revenue being recognized over the life of a software contract rather than at execution. This change will now allow software entities to recognize a much greater portion of the revenue at contract execution, even if it is a long-term deal.
This has multiple implications. It will allow software companies to recognize revenue when contracts begin, so the time period when the contracts are executed could show some impressive sales figures. This means less deferred revenue, which must be properly calculated going forward.
Another impact will be in sales commissions. Obviously, if commissions are based on when revenue is recognized, it could mean a huge windfall for a salesperson at the time of execution. But under the new standard, sales commissions can be capitalized over the life of the contract. Although revenue can be recognized at contract execution, which is a change, a company can capitalize and pay out commissions over the life of the contract.
From an auditing perspective, there will be more discussions with front-line employees who may not have typically been a part of the revenue recognition discussion. Front-line folks will have to certify there are no side deals, contract modifications, or even patterns or business practices which are different than the contract language. If payment is made on a time frame that’s different than your contractual language, that business practice will be a part of the revenue recognition calculation going forward. The same goes for any rebates, refunds, or discounts. Further, if you have third parties on the sales side, such as agents or distributors, auditors may need to speak with them going forward as well. The new standard will require additional conversations with your General Counsel’s office and legal team to ensure there is a contract management process that is followed and documented. Functional disciplines within your organization may need to document processes they have not done so for in the past.
Valuation questions will abound under the new standards. Basic calculations, such as the fair value of software in sales, service, and maintenance agreements, will take on new importance. Hybrid license arrangements—for example, those located on a customer’s premise and in the cloud—will become more important, as they will impact revenue based upon transfer of control. Even such basic contractual differentiations as additional licenses versus additional users take on greater importance under the new standard, as the definition could impact how revenue is recognized.
The Securities and Exchange Commission (SEC) has demanded more transparency in the entire valuation process. This is true for all parties, from audit down to the front-line salesperson. The process and documentation of it becomes much more important going forward. While the SEC will probably not come down too hard on any company during the first year of this new standard, they certainly will be watching and expecting more disclosures as companies make determinations of how they are going to recognize revenue going forward.
All of this means more volatility in revenue patterns. A large contract with 1,000 license seats could provide a significant revenue stream over the life of the contract. Now that revenue will be booked upon execution. Obviously, the revenue stream for the subsequent years will lessen, perhaps even down to near zero, as you will not have deferred revenue. For the software company that wants to go public, your valuation would typically be based upon a multiple of the cash flow. If cash flow is going to be more volatile, it is suddenly much more difficult to determine what the value of your company is going to be. This same problem exists if you are trying to go public or if you are seeking private equity-based funding. Those groups will be trying to figure out the value for a deal. This could lead to your company not getting the results from the market or private equity you may have been expecting.
The new revenue recognition standards for software companies are now in effect. It is up to your company to ensure your accounting standards are up to date and in line with the law’s expectations.