Revenue Recognition for the Technology Industry
December 5, 2019
Under new accounting guidance, the way we account for revenue is changing, affecting nearly every company preparing financial statements following Generally Accepted Accounting Principles (GAAP). Private companies are required to adopt this guidance for reporting periods ending December 31, 2019 and later. The new framework poses unique challenges for the technology industry, whose previous guidance on revenue recognition will be superseded. Ultimately, we anticipate less diversity in revenue recognition.
There are 5 steps to determining revenue recognition under the new standard:
- Identify the contract.
- Contracts may be in written, spoken, or implied. While this concept is defined in the guidance, you needn’t dwell on the word “contract.” Most transactions with a customer are considered contracts, and the absence of a signed contract does not prevent revenue from being recognized. Companies need to evaluate — and potentially revise — their contracts to ensure that the new standards are accommodated.
- Contract modifications are common practice in the tech industry. The new standard offers comprehensive guidance about whether a modification should be considered a separate contract altogether, or if the “old” contract should be terminated and replaced with a “new” version.
- Identify the performance obligations in the contract.
- A performance obligation is a distinct good or service that is promised to a customer (e.g. software license, customer support, software updates, hosting services).
- A good or service is distinct if the customer can benefit from the good or service on its own or with other resources readily available to the customer.
- Under legacy GAAP, post-contract customer support was considered a singular element; under the new guidance, it may now contain several distinct performance obligations.
- Determine the transaction price.
- The transaction price is the total consideration that you expect to receive from the contract. The caveat here is the word “expect”. It is common in the tech industry to provide discounts throughout contracts, and if they are reasonably assumed based on historical transactions, they must be accounted for. As a result, the transaction price could be less than the amount dictated in the contract, and there is a greater likelihood of deferral of revenue.
- Deferred or advanced payment terms are common. The new guidance addresses both, and now a significant financing component in a contract can result in recognizing interest income or expense.
- Allocate the transaction price to the performance obligations identified.
- The transaction price is allocated to each of the identified performance obligations based on the standalone selling price of those goods or services. The easiest way to determine this price is through directly observable prices, or the price point of the good or service when it’s sold as a standalone item to another customer.
- Determining standalone selling price could prove difficult if you don’t actually sell the services separately, or if the services are sold separately at different prices to different customers depending on the size of the customer. In the absence of a directly observable price, companies may continue to use the residual approach in determining a selling price.
- Recognize revenue when (or as) the performance obligations are satisfied.
- Revenue can be recognized as the performance obligation is satisfied under certain circumstances. For example, a “Software as a Service” company will generally be able to recognize revenue over the life of the contract, assuming the customer receives and consumes the benefits of the service simultaneously.
- If certain conditions are not met, revenue must be recognized once the performance obligation is completely satisfied.
The incremental costs of obtaining a contract are capitalized under the new guidance and amortized over the life of the contract. Commissions for signing a customer to a long-term contract would fall into this category. There is a practical expedient to expense incremental costs for contracts that are one year or less. There are additional disclosure requirements under this guidance, mostly pertaining to the judgments made in the revenue recognition process. While your current revenue disclosure could be a paragraph in length, you might see this grow to a half page or more after adoption.
While this new guidance is elegant in its 5-step process, it comes with a lot of new questions and requires more judgment. It is entirely possible that revenue recognition will not materially differ under the new guidance. Conversely, it may significantly affect the timing and amount of revenue recognized in a period. Nonetheless, tech companies should undergo an analysis to ensure that proper controls and documentation are in place to consider all revenue transactions in this new light. The Geffen Mesher team is happy to provide additional resources and guidance to help with this process.