The Way Technology Companies Recognize Revenue is About to Change Significantly
by Andrew Walker, CPA
For many technology entities, top line revenue is one of the most important metrics for both business owners and investors. Murky guidance and lack of comparability with international reporting has long been a complaint from the readers of financial statements. The Financial Accounting Standards Board (FASB) has listened to the users of financial data and issued one of the most significant changes to U.S. GAAP reporting in history.
FASB has issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers, effective starting in calendar year 2019 for privately held companies. This new guidance is aimed to provide the clarity and useful data demanded in today’s data rich environment. FASB has outlined a five-step model based on the core principle that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration the seller expects to be entitled in exchange for those goods or services.
The Five-Step Model
A five-step model has been developed to detail specific steps to know when and how much revenue to recognize. This model has been designed around a concept of “performance obligations.” The steps to recognition are as follows:
- Determine and identify the contract with your customers
- Identify the actions items (performance obligations, including implicit promises) in the contract
- Determine the total price (value) of the contract
- Allocate the price to the actions items (performance obligations) in the contract
- Recognize revenue as the action items in the contract are completed (satisfaction of performance obligations)
In addition to improved comparability and consistency on the income statement, the new standard requires improved disclosures to increase transparency and usefulness of financial statements. Under the new guidance, entities are now required to disclose enough information to allow users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Both qualitative and quantitative information is required about:
- Detailed revenue and information about amounts to be collected in the future and uncompleted action items (performance obligations).
- Significant estimates and changes in estimates for determining the completion of action items (performance obligations) in the contact and or price (value) of the item.
- Capitalized expenses related to the costs to obtain or complete a contract (i.e. commissions).
What’s the Impact on Technology Entities?
The updated guidance in ASU 2014-09 will affect every entity differently based on unique contract terms. Many technology entities are seeing changes in the timing of revenue recognition compared to legacy industry guidance. Further impact can be seen on the increased disclosure requirements and the resulting changes to accounting policies and software.
Business owners and management will have to adjust to several industry-wide changes. This includes the recognition of license fees. License fees for items such as software and SaaS platforms cannot be recognized before the period for which the customer is able to use the license. This change to recognizing revenue when the performance obligation is met (access and use) could advance/delay revenue that was previously recognized when the risk and reward of ownership was transferred to the customer.
Nonrefundable setup/up-front fees are also likely to receive different treatment under ASU 2014-09. Fees paid that relate to a specific service or product, representing a material right, are recognized over the period of benefit for the specific material right. Consequently, fees that do not relate to a specific service, product, or material right should be recognized as revenue as the related service or product is transferred to the customer.
Along with recognition of license, setup, and up-front fees, users of the financial statements will also be impacted by the corresponding recognition of costs of obtaining these contracts. An entity will be required to capitalize the incremental costs of obtaining a contract, including all costs that the entity would not have incurred if the contract had not been obtained. Common costs that will be capitalized include sales commissions paid for acquisition of new contracts, renewals, and extensions. These costs should be amortized over the period of the contract. It is permitted to expense all costs with an amortization period of one year or less.
How to Prepare
Business owners and management should begin consulting with their CPA to discuss the underlying impact of the new standards. With an effective date of January 1, 2019 for many businesses, it is important to modify any contracts and accounting systems before the period of change begins. Entities also need to ensure they are prepared to disclose disaggregated revenue to investors, bankers and other users of the financial statements.
For further revenue recognition discussion contact Andrew Walker at 678-359-9543