The accounting world has been debating the pending changes to how revenue is recognized for nearly a decade. The new standard (ASC 606) for revenue recognition became effective for public companies beginning January 2018 and nonpublic companies are on deck next, starting in January 2019.
This article highlights some of the areas technology companies should be addressing as part of their transition to the new revenue recognition standard. For a more thorough analysis of the implications of ASC 606, download the whitepaper Frazier & Deeter co-authored with the law firm of Morris, Manning and Martin, “Are You Ready for the New Revenue Recognition Standard?”
Under the old standard, a company could not recognize revenue until there was persuasive evidence of an arrangement. Under the new standard, the question is whether an agreement between the parties (written, oral or even implied) creates legally enforceable rights and obligations between them. Under the new standard, a contract may be written, oral, or even implied by an entity’s customary business practice as long as it creates enforceable obligations.So what does the change mean for technology companies? ASC 606 will arguably have the most significant impact on software and Software-as-a-Service (“SaaS”) companies. As a result, many tech companies will be required to modify their systems, processes, controls, and documentation to meet the new standard.
With the new standard, the company must account for a legally-enforceable contract with a customer when all of the following criteria are met:
- Contract has been approved and the parties are committed
- Each party’s rights are identified
- Payment terms are defined
- Contract has commercial substance
- Collection is probable
Although the criteria noted above are similar to Legacy GAAP, it is important to emphasize that the most significant difference is a new focus on whether an arrangement with a customer is legally enforceable. To properly assess revenue under the new standard, it is critical to understand all contractual obligations your company might have with a customer, whether written or implied, and when the obligations are enforceable.
So what are some of the key questions tech companies need to consider? The list below is not a comprehensive list. For a more detailed discussion of these topics and more, please see our related whitepaper.
- Do our contracts typically have amendments, side agreements or modifications?
When evaluating contracts with customers, ensure that all amendments and side agreements are captured and evaluated for proper revenue recognition. These are promises to the customer, even if the promise is not in the contract.
- How are we handling any financing terms offered to customers?
Under the new standard, extended payment terms no longer result in a deferral of all license revenue as was required under the old standard. For software companies, this is a significant advantage, and understanding how transaction prices need to be adjusted will be important going forward.
- My software contracts currently include post-contract support (PCS), which in the past required that we establish vendor specific objective evidence (VSOE) to determine when the revenue could be recognized. Do we still need to do that?
No. The FASB has explicitly eliminated VSOE and any references to PCS. Eliminating VSOE is a major (and welcomed) change in determining revenue recognition. In general, technology companies may find that there is opportunity to accelerate revenue recognition for certain promised goods or services (that were previously bundled with PCS) for which they previously could not demonstrate VSOE.
- How do we account for bundled services such as support, updates, etc.?
Under the new standard, these are four separate performance obligations (software license, installation services, updates, support) and you would recognize revenue as each one of the four obligations is fulfilled. Tech companies will need to reevaluate their customer contracts to determine how many performance obligations (referred to as “elements” or “accounting units” under the old standard) are within the context of the contract.
- Do you pay commissions to your sales personnel?
Under the old standard, sales commissions could be (and generally were) expensed. Under the new standard sales commissions that relate to revenue recognized over a period of time must be recorded as assets to be amortized over the revenue recognition period rather than expensed immediately. The amortization is over the expected length of the relationship, even if it is longer than the initial term of the agreement.
- Do your contracts have variable consideration, such as discounts, rebates, credits, performance bonuses or royalties in them?
Under the new standard, variable consideration must be estimated and included in the transaction price, subject to a “constraint.” Most contracts with customers contain some form of variable consideration, and requiring a company to estimate variable consideration is a significant change.
For a more detailed discussion of how technology companies will be impacted by the change to the accounting standard for revenue recognition, please complete the below form in order to view the whitepaper we co-authored with the law firm of Morris, Manning & Martin. Want to talk to an accounting expert? Send us an email now.