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New Revenue Recognition Standard Means Big Changes for Software Companies
The Financial Accounting Standards Board’s (FASB) new principles-based rules on revenue recognition will significantly change the way your software company determines when and how to recognize revenue. Forget the industry-specific guidance you’ve used before and prepare to make the following changes:
- If you’ve relied on the residual method for recognition of perpetual license revenue, you’ll have to switch to a different method.
- You must evaluate multiple-element arrangements to identify performance obligations.
- Contract consideration that was allocated based on vendor-specific objective evidence (VSOE) of fair value may have to change. The transaction price may have to be allocated to separate performance obligations based on their relative standalone selling prices.
- The requirement to have a fixed or determinable selling price for revenue to be recognized has been replaced with a requirement to assess whether variable consideration can be included in the transaction price.
These changes to the VSOE requirement and fixed and determinable selling prices (above) could accelerate timing of revenue recognition. Previously, revenue was deferred or not recognized until uncertainties were resolved. Extended payment terms that previously resulted in revenue deferral must now be evaluated differently. You must determine whether they represent a separate financing activity outside of revenue recognition or have an impact on the transaction price or collectability.
The timing for compliance with these changes is:
- For public reporting entities — annual reporting periods beginning after December 15, 2017.
- For nonpublic companies —interim periods within annual reporting periods beginning after December 15, 2018 (or early adoption following the public reporting entity timing).
Revenue recognition core principle
Under the new rules, FASB’s core principle for recognizing revenue is this: Revenue should only be recorded when goods and services are transferred to a customer at an agreed-upon price.
Following are the five steps to achieve this core principle:
- Identify the contract(s) with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the entity satisfies a performance obligation
Within each step, your software company has decisions to make, and there are some new definitions to consider. It is critical to involve areas of your company outside of accounting and finance, including sales, marketing, and legal, to gauge how these changes influence company business practices and revenue recognition.
Implementation challenges for software companies
A number of challenges arise when implementing these rules, including the many types of contractual arrangements, variety of products and services provided (performance obligations), and ways that customers pay for products and services (the transaction price).
For software companies, the following areas (among others) need to be evaluated, as accounting may be impacted under the new guidance:
- Multiple element arrangements
- Sales of software with bundled services
- Post-contract customer support
- Sales- or usage-based royalties
- Extended payment terms
- Sales to distributors using the sell-through method
- Bill and hold arrangements
- Return and refund rights
Take inventory of revenue streams and assess sales processes and systems
You can begin your assessment of the new rules by creating a list of all revenue streams with current customers. Software revenue often includes, but is not limited to: licenses, integration and implementation services, post contract support, warranties, consulting services, and related hardware and installation. Once you’ve identified revenue streams, you can start to assess your performance obligations under the contracts.
For those contracts with potential accounting changes, consider the need to revise contracts with customers prior to the effective date of the standard. Evaluate your existing sales processes and systems to ensure that they can handle different decisions and required documentation.
Disclosures require new information and processes
The new standard calls for additional disclosures surrounding revenue transactions. These include qualitative and quantitative information about contracts, the significant judgments (and changes in those judgments) made in applying the standard, and any recognized assets or liabilities related to costs to obtain or fulfill contracts. They are required for each period for which an income statement is presented and as of the date of each balance sheet presented. These disclosures may be challenging to prepare and require new information and processes that do not currently exist.
More guidance forthcoming
A transition resource group (TRG) was formed to identify implementation issues, advise the FASB and the IASB so they can determine if actions are needed to address the issues, and provide a forum to learn about the new guidance. The AICPA has also created a Revenue Recognition Working Group, and task forces are studying specific implementation issues unique to 16 industries, including software.
Although the new guidance is principles-based, it is critical that companies across the software industry apply it consistently so that similar types of revenue transactions are accounted for the same way from company to company. Securities and Exchange Commission officials expect consistency for public reporting entities.
How we can help
Because the effective date for these standards was deferred, many companies have delayed getting started or think the impact on their accounting won’t be significant. But it will. Given the efforts involved and the need to reassess processes, systems, and controls and document your discussions, the time to start is now. CLA’s software industry professionals have studied the new revenue recognition rules and can help you evaluate how these changes will impact your company. We have experience with all types of software companies and the accounting and business issues you face.