What the FASB’s New Revenue Recognition Guidelines Mean for Technology Companies

After years of debate, the Financial Accounting Standards Board (FASB) has issued final new guidelines on revenue recognition. The rules, which total 700 pages and represent a fundamentally new model for recognizing revenue, become effective in 2017 for nearly all public companies and the following year for nonpublic entities. Although this seems like a long time away, there are important decisions companies must make—and actions they should take—very soon to comply with the new rules.

The new guidelines will supersede long-standing industry-specific rules. Familiar concepts such as “persuasive evidence of an agreement,” “delivery,” and “fixed or determinable fees” will be eliminated. Instead the new rules will be more principles-based. Companies will have to apply significant judgment to determine the timing and amount of revenue recognition. This may be challenging for technology companies that have grown accustomed to today’s rigid, rules-based revenue recognition requirements.

Interestingly, for many technology companies, the new rules may accelerate the timing of revenue recognition versus today’s GAAP guidelines. For example, vendor-specific objective evidence (VSOE) of the fair value of post-contract support (PCS) will no longer be required to unbundle a software license arrangement. This means the new rules may allow for a sizable portion of the license fee to be recognized upon delivery of the license to the customer, with the balance recognized over the PCS period. In determining the amount of revenue to recognize, a licensor will have to apply judgment, estimating the stand-alone selling prices of both the software license and the PCS even if there’s no history of selling either item separately.

For cloud and similar service providers, the new rules will make it more challenging to evaluate whether and how to unbundle integral services from license or software-as-a-service deliverables. In addition, management will need to evaluate potential “variable” revenues—contractual provisions that can cause revenues to go up or down—throughout the life of the agreement. Things like downstream royalties or, conversely, potential liquidated damages will need to be estimated at the outset of an arrangement and potentially considered in the measurement of contract revenues from day one. Such estimates will be reevaluated each reporting period.

Perhaps most important, the new revenue guidelines affect more than just financial reporting. There may be tax implications, and certain business practices could change. For instance, once the rules become effective, companies may decide to begin sharing product road maps with customers, since doing so will no longer risk delaying revenue recognition until new features are commercially available. In addition, companies may wish to reevaluate their commission policies, presuming the new rules accelerate the timing of revenue recognition.

Given the importance the new revenue rules place on identifying the “customer contract,” companies may need to consider whether legal agreements will need to be modified to better reflect current business practices. Furthermore, it will be important to reevaluate whether such contracts remain legally enforceable in the jurisdictions in which the companies transact, especially internationally.

With any new set of regulations, companies will be required to update their policies, systems, processes, and internal controls. Audit committees and executives will have to review, approve, and monitor these changes. This is especially important at public companies where C-suite executives sign the quarterly Sarbanes-Oxley certifications.

Let’s examine in greater detail how the new revenue rules will affect technology companies and highlight what companies should do before the end of 2014 to prepare for the sweeping new changes.

Overview

In May the FASB issued Accounting Standards Update 2014-09, which introduced new Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers. The main principle of Topic 606 is that a seller should recognize revenue when the customer obtains control of a good or service, in an amount to which the seller expects to be entitled in exchange for those goods or services.

To apply this principle, the FASB has developed a five-step approach to determine when revenue from customer contracts should be recognized:

The revenue recognition model in Topic 606 applies to nearly all types of revenue-generating transactions. Consequently, once Topic 606 becomes effective, most of today’s industry-specific revenue practices will be eliminated. This includes the long-standing software revenue recognition guidelines in ASC Subtopic 985-605 as well as technical practice aids and other industry interpretations that have been developed and applied consistently over the past 20 years.

Possible Implications

Technology companies will likely account for transactions quite differently under the new revenue guidelines. The new rules will also require the significant application of judgment, even more so than under today’s GAAP.

In addition to the examples mentioned at the beginning of this publication, the following describes some other possible ways revenue and expense recognition may change under the new rules.

Sales to Distributors

Under today’s GAAP, many original equipment manufacturers or software developers use the sell-through method when recognizing revenues from sales to distributors. Under this method revenues aren’t recognized until the product is sold through the sales channel to the end customer. This accounting policy is appropriate when distributors are afforded generous return rights, price protection privileges, or other entitlements that call into question whether the arrangement fee is fixed or determinable—a necessary condition for revenue recognition under today’s GAAP.

Under the new guidelines, revenues are recognized upon transferring control of a good or service to the distributor regardless of whether the arrangement fee is fixed or determinable. However, the amount of revenue reported may be constrained somewhat to reflect the variable pricing risk. Thus, in substance, the new rules eliminate the sell-through method of revenue recognition and instead require more judgment in determining the amount of revenue to recognize upon transferring control of products to a distributor.

Time Value of Money

Current GAAP precludes immediate revenue recognition when a software licensor provides a customer with extended payment terms beyond 12 months or otherwise normal business practices.

Under the new revenue guidelines, a company would have to consider whether there’s implicit financing when extended payment terms are offered. If so, the financing element is accounted for separately from the rest of the contract.

To demonstrate, assume a software developer delivers a license to a customer and provides a three-year payment plan. Current GAAP would prohibit revenue recognition until payments become due and payable. Conversely, the new rules would require the licensor to reduce the transaction price by an estimate of the implicit interest income embedded in the extended payment terms. The licensor would recognize that discounted price as revenues upon license delivery, when control to the software license is transferred to the customer. The interest income would be recorded over time.

Residual Method

Today, software developers are permitted to use a residual method when there is VSOE of the fair value of undelivered elements such as PCS but no similar evidence of the price at which delivered items are sold on a stand-alone basis. For example, let’s say a developer licenses software, together with one year of PCS, for $10,000. If the VSOE of the PCS is $2,400, the developer could recognize revenue of $7,600 upon delivery of the license to the customer using a residual approach.

Although the residual method is still technically permitted under the new revenue rules, its use will be far more limited and less common. This is because the new guidelines require that companies estimate the price at which each separate performance obligation in an arrangement would be sold on a stand-alone basis. If using the residual method is inconsistent with this principle, another estimation technique must be used to arrive at the estimated stand-alone selling price. Making this evaluation will involve significant judgment in practice.

PCS

Under current GAAP, all components of PCS—such as 24x7 telephone support, “when and if available” upgrades, and bug fixes—are typically viewed as a single accounting unit. The total transaction value attributed to the PCS accounting unit is recognized ratably over the PCS period.

However, each component of PCS may be viewed as a “distinct performance obligation” under the new revenue rules. This is because components’ individual performance may not be interrelated or dependent on one another. For example, telephone support is primarily geared toward helping address user issues related to the current software, whereas the unspecified product upgrades may be based on the software developer’s internal product road map or discussions with customers about future feature enhancements.

Accordingly, companies may need to further break down amounts traditionally allocated, in aggregate, to PCS. As a result, the timing of revenue recognition for unspecified upgrades may change from the straight-line approach used today.

Integration and Other Services

Under current GAAP, the accounting for bundled services—such as integration or implementation—can be complex. Companies need to first evaluate whether the services are within the scope of industry-specific guidelines such as ASC 605-20 (separate-priced equipment maintenance) or ASC 985-605 if they’re software-related. Then companies have to determine whether the services can be unbundled from other deliverables and, if so, when they can be recorded as revenues. In many cases revenue recognition is often delayed at least until the service is 100 percent complete based on strict rules-based standards.

The new rules may allow for earlier recognition of service revenues for a few reasons. First, it will often be easier to unbundle services from other deliverables under the new guidelines versus current GAAP. Moreover, the new standards may permit more services revenues to be recognized over the period of time the benefits of the service are transferred to the customer. This is especially true if the service is enhancing an asset the customer already controls or if the service can benefit only that customer and the contract allows for the service provider to recover all costs incurred—plus a reasonable profit margin—in the event the contract is terminated early.

Variable Revenues

Some technology contracts call for fixed and variable consideration. For example, a company may deliver 10,000 licenses to a reseller in exchange for an up-front payment, plus a potential royalty each time the customer meets certain sales milestone targets as it resells the licenses to end users.

Current GAAP generally doesn’t allow a company to recognize variable or downstream revenue until the milestones are achieved or other contingencies are resolved. However, the new guidelines require that all revenue, including contingent or variable revenue, be considered at the onset of the agreement. Hence it’s possible that estimates of variable consideration would be recorded as revenues upon delivery of a product or service, well in advance of actually meeting the conditions that trigger payment of the contingent revenue.

In-Transit Loss Coverage

Technology companies will often ship physical products FOB shipping point or using similar terms. Legally, the risk of loss passes to the customer once the product leaves the seller’s plant or warehouse. However, to maintain strong customer relationships, some companies protect their customers from any risk of damage while the products are in transit even though there’s no obligation to do so.

In these circumstances current GAAP prevents companies from recognizing revenue until the products arrive at the final customer location. But under the new guidelines, a seller that provides in-transit loss coverage may have two performance obligations—delivering the units and insuring them while in transit. Revenue from the former would be recognized when control transfers to the customer, presumably at shipment. Revenue from the latter would be recognized once the de facto insurance services are provided. Again, judgment would be necessary to reach a formal conclusion.

Bill-and-Hold Sales

Many technology companies and their customers find it cost effective to produce large batches of products, such as chips. In some cases a customer may want to purchase the entire production output but not take physical delivery of all of the units until a later point in time. This is referred to as a bill-and-hold arrangement.

Under current GAAP, revenues typically cannot be recognized from bill-and-hold sales until the units are physically delivered to the final customer location. The new revenue rules, however, may view a bill-and-hold arrangement as having two performance obligations—producing units and storing them. Revenues from the former would be recognized when control transfers to the customer, such as when the units are completed, the buyer has inspected them, and title to the goods has legally passed to the purchaser. Revenue from the storage services would be recognized over time. Again, evaluating the proper accounting for this and similar fact patterns will involve judgment.

Contract Acquisition and Fulfillment Costs

Today’s GAAP provides limited guidance on the accounting for contract acquisition and fulfillment costs. Consequently, there’s diversity in practice. Some companies expense these costs as incurred, while others defer and amortize.

Under the new rules, contract acquisition costs (such as commissions) must be deferred and amortized on a systematic basis if the contract will be fulfilled over more than a year. If the contract will be completed in 12 months or less, contract acquisition costs may be expensed as incurred, at the seller’s election.

Contract fulfillment costs necessary to complete performance obligations—such as expenditures to reconfigure a plant to manufacture a product to customer specifications—must be deferred and amortized on systematic basis, consistent with how revenue is recognized. Contract fulfillment costs don’t include items addressed in other ASC topics such as software capitalization or inventory.

Why the Urgency?

If the new revenue rules don’t become effective until at least 2017, why is it so important to begin analyzing the potential effects today?

It’s a fair question. It’s easy to understand the natural inclination to wait until closer to 2017 to begin working through the new rules, especially given that early adoption is prohibited. In addition, the FASB and its overseas counterpart, the International Accounting Standards Board (IASB), have formed a transition group that may result in further tweaks to the new rules over the next few years. And, frankly, there have been false starts in the past around supposed imminent changes to lease accounting and even adoption of International Financial Reporting Standards.

However, in this case the new revenue recognition rules have been issued, and both the FASB and the IASB are committed to their implementation. The SEC is also very supportive of the boards’ efforts. So there’s no chance the new rules will be rescinded.

In addition, the new rules are long, complex, and involve judgment to apply. Waiting until 2016 to think about how the new rules may alter your company’s financial reports is far too late, especially given the internal control and policy changes necessary to account for customer contracts that cross accounting periods.

Perhaps most important, the new rules may affect more than just your US GAAP financial statements. For example, when companies defer revenues for financial reporting purposes, they’re often entitled to do the same for tax purposes, even if cash has been collected in advance from the customer. Since the new revenue guidelines may accelerate the recognition of revenue in certain situations, taxable income—and the obligation to make cash tax payments—could be similarly pulled forward.

Operationally the new revenue recognition rules may also inspire companies to take a second look at certain business practices. For example, you may want to reexamine your commission policies, especially if revenue recognition is accelerated under the new guidelines relative to current GAAP. In other words, is it appropriate to pay sales commissions earlier simply because the revenue recognition rules have changed?

In addition, current revenue rules can be extremely punitive when it comes to sharing product road maps with customers. In particular, any sort of commitment—express or implied—that future versions of a product will contain specific features is viewed as a performance obligation under today’s GAAP. In most cases this commitment will cause a company to defer all revenue until the new product feature is introduced, which of course could be years following the delivery of an initial product or service. For this reason, many technology companies have put strict rules in place around discussing product road maps with customers.

The new revenue recognition guidelines don’t contain severe penalties for committing to specified features in future product releases. Often revenues will be recognized upon transferring control of initial goods or services to a customer, with some portion of the arrangement fee deferred until the new feature is released. Accordingly, your company may decide it’s more appropriate to collaborate with customers around product road maps, since doing so will no longer risk delaying all revenue recognition until committed features are commercially available.

Finally, given the importance the new revenue rules place on identifying the “customer contract,” you may need to modify legal agreements to better reflect current business practices. Thus, the new revenue guidelines will afford you the opportunity to revisit and improve your company’s standard contract templates and sales terms and conditions.

In addition, you should evaluate whether such contracts remain legally enforceable in the jurisdictions in which your company transacts. For companies that operate globally, this can be challenging, because a “legally enforceable contract” in China or India may mean something different than in, say, Germany, the United States, or South Africa. But it’s critical to ensure each customer arrangement is legally enforceable—not only to mitigate commercial risk but also because the new rules require this assertion be supported before revenues can be recognized.

Actions to Take in 2014

Consider performing the following before the end of the year to prepare for adoption of the new accounting rules.

Evaluate the Financial Reporting Effects

As a first step, finance teams should read the standard—all 700 pages of it, unfortunately—then run the company’s current revenue transactions through the model. In some cases contractual arrangements will be accounted for in the same way as current GAAP, but for different reasons. In other instances the timing of revenue recognition will change, sometimes dramatically.

Companies may find that significant time currently spent on certain areas—for instance, around establishing VSOE—may no longer be necessary under the new revenue model. However, new judgments and analyses, such as those around estimating variable consideration and stand-alone selling prices, will probably more than replace those existing efforts.

In perhaps more than a few cases, it will be unclear how to apply the principles in the new revenue guidance to a given transaction. It may be helpful to discuss these gray areas with your accounting advisor.

Finally, companies will want to:

  • Communicate the expected effects of adopting the new guidelines to key stakeholders, including management, investors, and creditors
  • Draft disclosure of the potential effects of adopting the new revenue guidelines for inclusion in SEC filings or other financial statements
  • Identify whether the new rules will negatively affect debt covenants and, if so, begin negotiating amendments or waivers with lenders

Consider Whether Any Commercial Practices Should Change

As mentioned previously, the new revenue rules provide an opportunity to reexamine sales commission policies and assess whether to ease off restrictions around discussing product road maps with customers. It would be prudent to begin thinking through these important decisions before the end of 2014.

In addition, recall that the new rules don’t require arrangement fees to be “fixed or determinable” to recognize revenues. Hence you may want to assess whether to be more aggressive in granting allowances or offering customer discounts, concessions, or promotions to customers to foster growth and improve customer relationships. From an accounting perspective, doing so will affect the amount, but not necessarily delay the timing, of revenue recognition.

Begin Planning for Other Operational Changes

Companies may adopt the new rules on either a full retrospective or modified retrospective basis. Either way, data for at least some contracts will need to be tracked for periods prior to the adoption date—that is, from 2016, 2015, or even earlier. This means every company should decide as soon as possible—and certainly before the end of 2014—which method it will use to transition to the new rules.

This decision will drive the nature, timing, and extent of any necessary systems and process changes. For example, companies that elect full retrospective adoption will almost certainly want systems in place before the end of the year to track how revenues will be recognized under the new rules for all outstanding contracts, even while continuing to report under current GAAP rules until the date of adoption. Even companies that will transition using the modified retrospective basis should begin the arduous process of updating systems to track new performance obligations, estimates of variable consideration, and other data necessary to comply with the extensive disclosures required under the new rules.

The selection of a transition method is also important because it can affect reported trends, perhaps in surprising ways. To demonstrate, assume that on December 31, 2016, a calendar-year-end publicly traded software developer delivers a software license, together with three years of PCS, for $12 million. On a relative stand-alone selling price basis, the license would be allocated $9 million of the arrangement price and the PCS would be allocated the remaining $3 million.

However, assume there’s no VSOE of the fair value of the PCS. Thus, under current GAAP, no revenue would be recognized during 2016 and the entire license fee would be recorded over the three-year PCS period, or $4 million per year beginning in 2017. Under the new revenue rules, $9 million in revenue would be recognized in 2016 upon delivery of the software license and the balance would be spread over the PCS period.

What does this all mean? If the software developer elects to use a modified retrospective adoption approach, $9 million of revenue would disappear. Why? For starters, under a modified retrospective transition approach, past periods aren’t restated. Hence, even in the 2017 financial statements, the comparative 2016 accounting period wouldn’t show any revenue related to this software license because this is reflective of how current US GAAP would account for the transaction.

Upon adoption of the new rules, the software developer will book a catch-up entry to January 1, 2017, retained earnings for the difference between the revenues that would have been recognized under the new rules in 2016 ($9 million) versus what actually had been reported previously ($0). Thus, the software developer would book a $9 million adjustment to opening retained earnings, removing this amount from deferred revenues upon transition. Accordingly, $9 million of revenues never gets reported in any accounting period, leading to some difficult trends to explain to shareholders and other financial statement users.

Finally, besides the potential income tax effects of adopting the new revenue guidelines, there may be sales and use tax considerations as well. For instance, the new rules may require arrangement consideration to be allocated to performance obligations differently from today’s GAAP. In fact, the allocations may not be consistent with the breakdown on the customer invoice. Since some obligations may be subject to sales and use tax while others may not, your company should begin identifying which taxing authorities follow GAAP allocation rules (there actually may be quite a few that do) and updating tax compliance systems accordingly. This is especially important for providers of cloud services, where sales and use tax laws continue to evolve.

We’re Here to Help

Adopting the new revenue recognition guidelines is a significant undertaking that will involve more than just your company’s finance and controllership teams. Moreover, the impact of the new rules goes beyond just financial reporting—there are important tax, legal, and commercial considerations as well.

As a result, it’s critical to begin evaluating how the new rules will affect your business, from both an accounting and operational perspective. A number of steps ideally should be completed before the end of 2014, or else it will be difficult to make the proper transition when the rules do become effective.

For more information about the new revenue recognition guidelines or for help evaluating their impact on your business, contact your Moss Adams professional.