Revenue Recognition for Technology Entities
June 5, 2018 - By: SC&H Group
With the 2018 effective date for the new revenue recognition standard issued by FASB quickly approaching, SC&H Group has pulled together a comprehensive series of industry specific resources. The following blog post summarizes revenue recognition concepts specific to technology entities that must be considered to ensure their accounting policies are aligned with the FASB’s new standard.
The new revenue recognition standard provides a five-step approach for recognizing and measuring revenue. This post summarizes some of the areas within the technology industry, broken down by each of the five steps in the model that may be affected by the new revenue model. It is important to remember the technology industry is comprised of numerous subsectors that each have diverse product and service offerings. Not all information in this post will apply to all technology companies.
Identify the contract with the customer
A contract can be written, oral or implied by an entity’s ordinary business practices. The new guidance states the agreement must be enforceable by law and as such, entities will need to consider federal, state and local laws. Technology companies should consider any history of entering into amendments, side agreements or modifications to contracts, whether verbal or written, as these all have specific implications for revenue recognition. Additionally, under this first step of identifying the contract, entities are required to assess whether collection of the consideration is probable which includes consideration of any price concessions expected to be provided to the customer.
Identify the contract’s separate performance obligations
Technology companies often provide multiple products or services as part of a single arrangement, including, but not limited to hardware, software, implementation services, customer support, maintenance and upgrades. Management must determine whether a product or service is distinct by assessing if the customer can benefit from the product or service with resources that are readily available to the customer. The new guidance eliminates the current recognition process of requiring vendor specific objective evidence (VSOE) of fair value.
The new standard provides guidance on accounting for licenses of intellectual property (IP). Management must determine if a contract includes a license of IP, particularly in a cloud based or software as a service (SaaS) agreement. In some situations it will be determined that the license is not distinct from other goods and services and in others the license will be distinct. For distinct licenses management must determine if the license is a right to use or a right to access the IP which will then determine whether revenue related to the license should be recognized at a point in time or over time.
Determine the transaction price
The transaction price is calculated as the amount of consideration the entity expects to be entitled less amounts collected by the entity on behalf of a third party (such as sales tax). It includes an estimate of variable consideration to the extent that a significant revenue reversal is not probable. Technology companies often enter into arrangements with variable consideration such as milestone payments, service level guarantees with penalties and refund rights.
Allocate the transaction price to the separate performance obligations
Technology companies often provide multiple products or services to their customer under one contract. Under the new standard, management must allocate the transaction price to each distinct separate performance obligation based on the relative standalone selling price of each obligation. The best evidence of a standalone selling price is the price management would charge for the product or services when the entity sells it separately.
Recognize revenue when or as the entity satisfies a performance obligation
Revenue can be recognized when a performance obligation is satisfied when the control of the product or service is transferred to the customer. The new guidance states the customer obtains control when they 1) can direct its use and 2) obtain substantially all remaining benefits from the product or service. Management should evaluate the transfer of control from the customer perspective. For IP, control may transfer when the customer takes possession of the software by physical receipt, download or receipt of a license key or access code. Management also needs to evaluate if the products or services are transferred over time or at a point in time which then determines if revenue is recognized over time or at a point in time.
FASB’s new model includes a variety of disclosure requirements, one of which relates specifically to significant judgements. The goal of the expanded disclosures is to eliminate “boilerplate” language and instead provide a more meaningful description of revenue recognition policies and how they are applied to contracts with customers.
While the standard does not specify the level of detail required, technology companies will need to disclose the judgments, and changes in the judgments, made in applying the new standard that significantly affect the determination of the amount and timing of revenue recognition. Specifically, technology companies will need to explain the judgements and changes in judgements used in the determining both of the following:
- The timing of satisfaction of performance obligations – For instance when a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time.
- The transaction price and the amounts allocated to performance obligations – For example in instances where the stand alone selling price is not directly observable, such as when a product or service is not sold separately, judgement is required to determine the appropriate information such as market conditions and other observable inputs to determine the stand alone selling price.
Nonpublic entities are required to adopt the new standard for annual reporting periods beginning after December 15, 2018 (December 31, 2017 for public entities). Implementation is to be done on a retrospective basis, so organizations should understand and account for revenue under the new standard at least a year in advance.
As a result of these standards entities need to reassess their current revenue accounting and determine whether changes are necessary. SC&H Group is here to help as you are navigating the best next steps to pursue. If you have any questions about revenue recognition specific to technology entities please Contact Us.