In this summary, you will learn:
- The effective dates of the new guideline for tech companies.
- What the new guideline is all about and its advantages.
- Any challenges that might arise when adopting the new guideline.
- The new revenue recognition guidance model has five core steps: identifying the contract, identifying the performance obligation, determining the price of the transaction, allocation of transaction price to different obligations, and finally recognizing the revenue when the performance obligation is satisfied.
- When identifying the contract with the customer, the company is also required to determine if the collection of the consideration is probable, including the collection of price concessions that the customer will be supplied with.
- With the new guideline, there is guidance for companies on accounting for IP licenses. Companies, therefore, need to confirm if any contracts entered into contains IP license either in form of a software service or cloud-based.
- Tech companies will be required to disclose the judgment and any changes in judgment it has made in the application of the new revenue recognition standards.
- Implementation of the new guideline is from 15th December 2017 for public companies and 15th December 2018 for private companies.
As much as the effective dates for the new guidance on revenue recognition seem to be far off, it is ideal for a company to be fully aware of what it needs to disclose and include when doing its financial reporting. This way, it will be complying fully with the regulations. The changes will affect various companies whether private or public in different ways. For tech companies that are more specialized in a certain sub-sector such as software, the changes will be most notable.
First, it is important to know the five steps required in this model. The first step is for a company to identify the contract that it has with its customers. According to the new guidance, contracts can be oral, written or implied, and enforceable by law. This means the company needs to consider whether the contract is enforceable by local, federal or state laws. As a tech company, it is important to consider any history of entering into side agreements, amendments or modification of any contracts entered into. This is because any of these actions carry specific implications when it comes to revenue recognition.
Secondly, the performance obligation for both parties needs to be identified. Usually, a single tech company can provide an array of services to its clients. Under the old guideline, companies are required to recognize the fair value for vendor specific objective evidence (VSOE). Under the new guideline, licenses for Intellectual Property (IP) need to be accounted for. The license could be distinct from other goods or not. A distinct license either gives the company the right to or right to access the IP, which in return will determine if the revenue will be recognized over time or at a certain point in time.
The third step involves the determination of the transactions price. To get the transaction price, the company needs to less any money that is collected on behalf of a third party such as taxes from the amount consideration it expects. For example, tech companies enter into contracts with variable consideration e.g. refund rights and payments based on milestones among others. The new guideline requires the transaction price to include an estimated amount of the variable consideration to the extent that a reversal of significant revenue is not probable.
The fourth step of the model is the allocation of the transaction price to various performance obligations. As mentioned earlier, tech companies may issue one contract but offer various services under that one contract. The new guideline requires allocation of prices on the specific products or services rendered. For example, if the contract has a provision of software’s implementation, maintenance and upgrading the systems, the prices for each service will be allocated such as $500 for software’s, $400 for maintenance and so on.
The final step is the recognition of revenue when or as the performance obligation is satisfied. It is important to note that a performance obligation is satisfied once the control of the services or product is transferred to the customer. Under the new guideline, there are two ways for a customer to obtain control: when they are able to direct its use and second, can get substantial use off the remaining benefits of the product or service. For IP, control can be transferred once the customer is in possession of the software either by having the physical receipt, downloading the receipt or receiving a receipt of the license key or access code.
As for disclosures, a tech company will need to disclose a number of things. The most important two disclosures include:
- The transaction price and amounts allocated to each performance obligation- because tech companies can offer an array of services under one contract, the stand-alone price might be hard to determine. If this is the case, judgment will be needed to determine the appropriate information needed to estimate the stand-alone selling price e.g. determining market conditions that affect pricing.
- The timing of satisfaction of performance obligations- this applies where the judgment will be choosing whether the product or service rendered is distinct or not. Is the software is distinct, then it will be accounted for separately. If it is not distinct, then it will have to be accounted for together with the cloud services offered and recognized over time.
The effective date for the new guideline is as of 15th December 2018 for private companies and 15th December 2017 for public companies.