New Revenue Recognition Rule Is Tricky for Software and Technology Companies
Accounting Standard Update (ASU) 2014-09 (Topic 606), Revenue Recognition — Contracts with Customers, fundamentally alters the way we think about financial reporting.
The new standard not only changes financial statement disclosures but also the way your company will account for revenue and related transactions. All industries are affected by the new standard, but companies in the technology sector may require the most in-depth analysis of the changes. This is largely because much of your work is characterized as intellectual property and your contracts and licenses tend to be complex and multi-layered.
To most stakeholders across the business community, revenue is arguably the most significant item in the financial statements. When you really review a set of financial statements, actual disclosures and information about revenue are relatively scarce, especially in comparison to certain other items with very robust disclosure requirements (e.g., stock-based compensation).
The connection between the importance of revenue recognition and the information provided by financial reporting wasn’t always clear, which was the impetus for the changes to the standard. Beyond additional disclosure, the timing of revenue recognition, as well as the treatment of incremental costs to obtain a contract, could change significantly for companies in the technology community — especially software developers.
The new principle-based approach is more conceptual than current generally accepted accounting principles (GAAP) and will require significant judgment to apply. You’re likely up to speed on the basics and even some of the finer details related to software companies in particular, but you’ll need a strong grasp of these nuanced financial reporting rules in order to truly prepare and comply.
“Right to access” versus “right to use”
The new accounting standard states that a company should account for a promise to provide a customer with “right to access” the company’s intellectual property as a performance obligation satisfied over time. This is because the customer will simultaneously receive and consume the benefit from the company’s performance of providing access to its intellectual properly as the performance occurs.
In contrast, a company’s promise to provide a customer with the “right to use” the company’s intellectual property is satisfied at a point in time, and thus revenue is recognized at the point in time at which the license is transferred. The underlying concept in the standard is control: When does the customer obtain control of the license? If given the right to access the company’s intellectual property, then control is being transferred over time, and revenue is recognized accordingly.
In determining revenue recognition for licenses, the difference between right to access and right to use must be understood in the context of the standard. The right to access intellectual property over time is inherent to symbolic intellectual property — that is, intellectual property with no standalone functionality (such as sports team’s logo or an animated character). The right to access would also apply to functional intellectual property such as a SaaS-based license agreement whereby the customer has access to the software during a period of time. In these cases, the contract will provide for a specified term of access, and in the case of certain hosted software, access can be turned on or off. Revenue is therefore recognized over the duration of the contract period, as the license and the online service that provides access to the software are highly interrelated and not distinct.
Functional intellectual property has standalone functionality which may include the ability to process a transaction or perform a specific action. A functional software program may be provided to a customer at a point in time, whereby the software is fully functional upon delivery/installation and can be utilized by the customer at a point in time.
In order to recognize revenue at a point in time, your company should have no further performance obligations related to the delivery of the software. If your company is expected to substantively change the software during the license period and your customer is contractually or practically required to use the updated software, this provides evidence that the license grants the right to access the software over time, rather than at a point in time.
Multiple element arrangements
The license of intellectual property, including software, often includes other elements as part of the contract. The fourth step in the revenue recognition process involves allocating the transaction price across all performance obligations. When a company sells products and services separately, there is typically clear evidence of the value of each item. When bundled, the transaction price must be reasonably allocated across the different performance obligations. This exercise becomes even more important when the different elements are recognized at various times.
For example, a license for a functional software program may transfer control to the customer at a point in time, but the contract may also include additional support services and updates which have not been separately priced in the contract and will be delivered at times in the future. The contract transaction price includes the value of those additional services and must be allocated and recognized when those additional performance obligations are met. Contracts may include numerous performance obligations such as maintenance, technical support, hosting, training, and other goods or services. Companies must take care to diligently identify the separate performance obligations, recognizing revenue appropriately as or when performance obligations are satisfied.
A question arises when an existing license is renewed: When can the revenue be recognized? FASB’s position is that the renewal of a contract should not be combined with the original contract, and that revenue related to the renewal may not be recognized until the beginning of the renewal period.
How we can help
All technology companies will experience changes in financial reporting as a result of the new revenue recognition guidance. Understanding the new provisions, and the specific areas directly affected, is imperative, and the time to act is now. CLA’s technology and software industry professionals can help you implement the new requirements and make the transition to the new standard as smooth as possible.