A critical, but often difficult-to-understand principle, revenue recognition is an accounting practice that determines the conditions under which revenue is accounted for. In fact, it’s so often misunderstood that is the leading cause of financial error among publicly traded companies. But revenue is a critical measure to define, as it is one of the top considerations used by investors when considering a company’s performance and potential.
The Financial Accounting Standards Boards recently issued new revenue recognition guidance to establish a consistent reporting model. Here, Bennett Thrasher’s Senior Manager of the Financial Reporting and Assurance Brian Hamm explains the new revenue recognition process and what entrepreneurs need to understand.
What are the new guidelines?
The new Accounting Standard Update will be effective for public companies with annual reporting periods after December 15, 2017, and for private companies with annual reporting periods after December 15, 2018, though earlier adoption is permitted (for periods beginning after December 15, 2016).
The new revenue recognition model includes the following:
- Identify the contract(s) with a customer
- Identify the separate performance obligations
- Determine the transaction price
- Allocate the transaction price to the performance obligation
- Recognize revenue when or as the performance obligation is satisfied
This is similar to the current process under multiple-element arrangements; however, attention to detail is needed as you dive deeper into the nuances.
What are some of the main differences between the current and new revenue recognition guidance?
There are four major differences that business owners in the tech community will need to take into account:
- Under previous guidelines, a company could ignore inconsequential or perfunctory performance obligations. This is no longer the case: a business owner has to look at ALL performance obligations determined to be distinct. Distinct is defined as meeting the following criteria:
- The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer, and…
- The promise to transfer the good or service to the customer is separately identifiable from the other promises in the contract
- The new principals say that variable payments from customers will need to be estimated at the contract inception and updated every reporting period. This is different from the current guidelines that require that any unfixed or TBD amounts to be considered part of the transaction fee only once the uncertainty is resolved. The new guidance relaxes those restrictions, allowing the contingent payments to be taken into account and estimated in the transaction price. This could potentially allow for greater revenue recognition in some contracts.
- When a contract has more than one performance obligation, the transaction price should now be allocated to each in an amount that depicts the company’s relative standalone selling price – and discounts should be allocated proportionally to all obligations. This is similar to current guidelines, but under the new guidance, if there is evidence that a discount included in the contract relates to some, but not all, obligations, that discount should be allocated to those specific performance obligations. In the past, if tech companies discounted set up fees, they would allocate that discount to every element in the arrangement. Now the company can apply the discount only to the specific performance obligations rather than the entire arrangement.
- Cost incurred in fulfilling a contract should be recognized as an asset if those costs meet certain criteria:
- Costs relate directly to a contract or an anticipating contract
- Generate or enhance resources that will be used in satisfying performance obligation
- Expected to be recovered
Direct and incremental cost of attaining a contract should be capitalized. Sales commissions are a great example of this- most tech companies will pay and expense sales commissions immediately upon entering into a contract. If those costs meet the criteria above, they have to be capitalized and expensed over the contract period.
What should management do to promote a smoother transition?
Especially in today’s SaaS-dominated startup world, the number of contracts grown every month, so starting a review early is critical. With upfront fees being recognized over the estimated customer relationship and the retrospective presentation, the contracts impacted by this change could have been put into place several years ago. Start the conversation now with your internal and external accountants.
Don’t be dissuaded by these new revenue recognition guidelines- the standardization and additional disclosures will assist business owners, investors, and others to understand and compare companies, and decide whether to invest in yours!
Bridgett Rich joined Acuity as Director of Development & Partnerships with 10+ years experience in accounting & finance. She uses her background from industry consulting at Deloitte to help entrepreneurs grow their businesses with a focus on startup businesses.