Issues in Implementing Revenue Recognition Rules
As entities adopt the new revenue recognition rules of the Financial Accounting Standards Board (FASB), Accounting Standards Update (ASU) No. 2014-09, “Revenue From Contracts With Customers” (as subsequently amended by the FASB), many are experiencing challenges in applying the new guidance. Following is a description of significant issues a technology company might face when applying the new revenue recognition approach. It is important for financial executives in the technology industry to keep these issues in mind when implementing the new rules.
For the latest industry-specific information on the new revenue recognition standard, check out the Crowe Horwath LLP Revenue Recognition Resource Center.
Elimination of Vendor-Specific Objective Evidence Criteria for Software Companies
Currently, under the existing standard, elements of a software licensing arrangement can be accounted for separately only if vendor-specific objective evidence (VSOE) of fair value exists for the undelivered element or elements. If VSOE does not exist, entities must combine the elements into a single unit of accounting and recognize revenue when or as the delivery of the last element takes place or until the company has VSOE for the remaining undelivered elements.
Many software entities do not have VSOE for a software license and thus are not able to recognize revenue upon delivery of the software license under ASC 985-605. This is an example of the criticism to U.S. generally accepted accounting principles (GAAP) revenue recognition rules prior to this new standard. Most other industries would be required to make an estimate of the revenue to allocate to delivered items and are not held to the strict VSOE criteria, resulting in similar transactions having significantly different accounting implications.
Under the new revenue recognition rules, a software entity may be able to recognize revenue for a delivered software license even if the entity does not have VSOE. However, for the licenses that meet certain criteria, the new rules will require software entities to recognize revenue upon delivery of the software. As a result, software entities may have to make estimates that would not have been required (or permitted) in the past. This results in increased comparability – but also in additional complexities for some software entities.
Complex Consideration Arrangements
Under the new standard, an entity will be required to determine the transaction price based on the amount of consideration to which it expects to be entitled. The amount to which the entity expects to be entitled may differ from the contract price. The transaction price may include variable consideration, such as contingent consideration due from the customer, consideration payable to the customer, and the time value of money for significant financing components.
Variable Consideration
Variable consideration includes arrangements that are relatively common such as rebates, price concessions, or discounts based on future actions. The new standard requires that any variable consideration be estimated at contract inception and that the amount of the consideration be included in the transaction price. Variable consideration can be estimated using either an expected value approach or the most likely amount. The method used to estimate variable consideration should be determined on a contract-by-contract basis and must be consistently applied. The new standard requires an entity to estimate variable consideration and include this estimate within the transaction price used to measure revenue. However, the entity is allowed to recognize revenue only to the extent that it is probable that a future reversal of revenue is not probable. This provision from the new rules is commonly referred to as the variable consideration “constraint” and is intended to restrain entities from recognizing revenue prematurely. The new standard also provides a limited exception to this variable consideration guidance. The exception, which will apply to technology companies, is that variable consideration related to sales or usage-based royalties on licenses of intellectual property should not be included in the estimate of the transaction price.
For more on variable consideration, visit crowehorwath.com/revenue-recognition.
Significant Financing Components
Companies also will be required to consider payment terms in the determination of the transaction price. Under the current guidance, entities may have to discount receivables from a customer when the customer is allowed to defer payment for more than one year from recording the receivable. However, the new guidance requires the entity to consider numerous factors in evaluating whether an arrangement includes a significant financing component. Significant financing components may exist even when a customer prepays for goods or services. As a practical expedient, the standard allows an entity to avoid assessing arrangements for significant financing components if, at the inception of the contract, the entity expects that the timing between the goods or services being provided and payment by the customer is one year or less. While this practical expedient is useful for many entities, any entity with contractual arrangements that are long term in nature (for example, multiyear subscriptions or projects expected to be serviced over more than one year) must carefully consider the guidance of the standard and may be required to recognize interest income (or expense) if the arrangement contains a significant financing component.
Learn more by visiting the Crowe Horwath LLP Revenue Recognition Resource Center.
Options for Additional Goods or Services
Some technology entities may provide their customers with options for additional services (or goods) at a discounted price. An example would be a software entity that sells a software license for $100,000 with post-contract customer support (PCS) services of $24,000 for one year of support. Included in the contract is a right for the customer to purchase an additional year of PCS for $12,000.
Under the current revenue recognition rules, options available to the customer are not recognized until the customer has elected to use the additional goods or services or has otherwise become contractually obligated for payment of them. In our example, the entity would be prohibited from recognizing revenue for any portion of the second year of the PCS services, prior to the customer electing such an option. Similarly, the entity would not recognize amounts related to the option until the customer has elected the option or the option expires.
The new revenue recognition rules require an entity to recognize a separate performance obligation for customer options if those options give the customer a material right. The entity may do this in either of two possible ways. The entity can either (1) recognize the option as a separate performance obligation or (2) “look through” the optionality of the arrangement and recognize a performance obligation for the goods and services to be delivered in the option. The primary difference between these two methods is that recognizing the option in the contract requires an entity to consider the probability that a customer will exercise the option, whereas the alternative “look through” approach ignores the probability of the customer’s election and treats the contract as an arrangement that includes all goods and services within the option.
Using either approach, the calculations required to recognize customer options that are a separate performance obligation can be highly complex. These calculations require the entity to make estimates related to (1) potentially, the probability of customers electing to purchase the additional goods and services and (2) the stand-alone selling price of the option or the additional goods and services provided by the option. In subsequent periods, customers may elect to not purchase the additional goods and services (or may do so at rates different from those estimated). These calculations can be further complicated if the option terms include a variable consideration component, a financing component, or nonstandardized terms.
Entities that grant customers options that are considered separate performance obligations may be required to allocate revenue to the customer option, potentially deferring revenue related to consideration received early in the contract and recognizing it at the point in time (or over the period) when optional goods and services are delivered.
Moving Forward
These are just some of the areas that technology companies are finding challenging. Financial executives in the technology industry should consider reviewing the issue papers of the Joint Transition Resource Group (TRG) for Revenue Recognition established by the FASB and the International Accounting Standards Board. In addition, the American Institute of Certified Public Accountants (AICPA) has formed 16 industry task forces, including one for the software industry, to help develop a new accounting guide on revenue recognition and assist industry stakeholders. Gaining an understanding of the issues under TRG and AICPA discussion will help preparers anticipate and handle implementation issues.
For more information on the new standard and helpful resources for your company’s implementation, visit the Crowe Revenue Recognition Resource Center: crowehorwath.com/revenue-recognition.