Publications
02.07.12
Proposed Revenue Recognition Model: A Positive Change for Software Companies?
by Stacy LaMontagne, Senior Manager and Edwin Lucas, Senior Manager
The Financial Accounting Standards Board (FASB) recently issued a revised exposure draft that proposes a significant overhaul of the revenue recognition guidelines currently used under accounting principles generally accepted in the United States of America (GAAP). These changes will eliminate the numerous industry-specific revenue recognition rules that have developed over the last few decades and replace them with one set of principles that are applicable to substantially all industries. One of the industries that will be most affected is the software industry.
Presently, revenue recognition rules for software companies are so complex and restrictive that, in many cases, the accounting for transactions does not reflect the intended business purpose of the contract. This often leads to financial statements that don’t necessarily reflect the true financial condition of the company. Under the proposed revenue recognition model, software companies will have more flexibility in packaging their products and services without many of the constraints the current rules impose.
Under the proposed model, revenue recognition is based on the satisfaction of performance obligations, which are similar to separate elements under current GAAP. Companies will be required to identify separate performance obligations in each contract and then allocate total contract consideration in proportion to the stand-alone selling prices for each obligation. For software companies, this is quite different from the current GAAP, which require strict adherence to the vendor-specific objective evidence (VSOE) requirement that in many instances results in revenue being deferred due to the inability to establish VSOE of fair value for undelivered elements. The proposed model allows companies to use more judgment when allocating revenue from their contracts. For example, today’s accounting rules typically consider post-contract customer support a single element in a contract. However, under the proposed model, a company might conclude that a warranty that includes bug fixes and support is a separate performance obligation from the right to receive unspecified software upgrades and enhancements, and revenue allocated to the latter may be able to be recognized sooner.
The revenue under the proposed model would be recognized based on when the customer takes control of the product or service, which could occur at a specific point in time or over a period of time. This could result in significantly different revenue recognition than under current GAAP. For example, if a software company is performing significant customization and modification of its product, revenue recognition may be delayed until the completed product is delivered, since that would be the point in time that the customer takes control of the product. In another example, a company that licenses its intellectual property currently may be required to recognize revenue over the period of the license. Under the proposed model, that same company may be able to recognize all of the license revenue at the time the license agreement is signed, since that is the point at which the customer obtains control of the rights to use the license.
Yet another significant change from the current guidance is that collectability will no longer be a threshold to revenue recognition. Presently, revenue cannot be recognized unless collectability is reasonably assured. Under the proposed model, revenue may be recognized earlier since collectability is no longer an issue. However, companies would now be required to present losses from uncollectable receivables in an adjacent line item to revenue in the income statement, as opposed to bad debt expense. This will provide the users of the financial statements with a better understanding of the amount of revenue that is expected to be uncollectible.
Companies will also be able to capitalize certain costs incurred to obtain a contract under the proposed guidance. For example, for software companies and most others commissions are a significant cost of obtaining a new contract. Most companies typically expense commissions at the inception of the contract or when the commission is earned, since it is considered a part of the sales process. For contracts with terms of at least one year, companies will now be required to capitalize commissions and other costs to obtain such contracts and amortize the costs over the related contract terms. In certain circumstances, costs incurred to fulfill a contract are also capitalizable. This return to the “matching principle” will likely have a positive effect on earnings for such companies.
This proposed revenue recognition guidance is expected to become effective in 2015 for public companies and in 2016 for private companies and will be required to be applied retrospectively. As most of us in the business world know, time passes very quickly. Software companies and most other companies for that matter would be wise to start considering the effect the proposed model will have on their contracting processes, pricing strategies and financial forecasts sooner than later. Proper planning and implementation could result in more favorable and meaningful revenue recognition, which goes right to the bottom line.
For more information on these proposed revenue recognition standards, please contact Edwin Lucas at elucas@argy.com or Stacy LaMontagne at slamontagne@argy.com.
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