It’s critical to begin evaluating how the new revenue recognition rules will affect your technology company from an accounting as well as an operational perspective.
Financial Accounting Standards Board (FASB) Accounting Standards Codification® (ASC) Topic 606 was introduced in May 2014 to revise how companies recognize revenue specifically from customer contracts. The rules are effective for public companies in 2018 and private entities in 2019.
At 1,000 pages, ASC Topic 606 is full of intricacies that need to be interpreted. Each new rule has financial, information system, legal, tax, and commercial impacts. Planning for these changes before the new rules take effect will put companies in a better position to compete.
Customer contracts and the resulting revenue often drive and determination businesses value; and the associated financial reporting has always been, and continues to be, a complex component of accounting in technology companies.
The new revenue recognition guidelines are designed to provide a more accurate and useful representation of what companies plan to earn from customer contracts.
Given the internal control and policy changes necessary to account for customer contracts that cross accounting periods, waiting until the new rules take effect will be too late to determine how they’ll alter your company’s financial statements and other business processes.
At a minimum, it’s prudent for technology companies to start assessing what’s going to change when the new revenue recognition rules take effect and to anticipate the potential challenges that might arise.
The main business process changes technology companies will encounter when transitioning to the new guidance include the following:
Financial reporting. The new rules mandated by ASC Topic 606 require that revenue is recognized by a seller when its customer obtains control of a good or consumes a service. These new rules will supersede long-standing, industry-specific accounting guidelines and will likely result in wholesale changes to financial reporting and information systems, legal contracts, tax, and other key business processes that are currently set up to abide by the existing rules.
Judgment. Companies will have to apply significant judgment to determine the timing and amount of revenue recognition under the new principles-based standard, which may be challenging for technology companies that have grown accustomed to the previous rigid, rules-based revenue recognition requirements.
Increased Flexibility. The new revenue recognition guidelines lack negative implications for committing to specified features in future product releases. This is a notable change from previous guidance that imposed restrictions many technology companies faced when discussing product roadmaps with customers. It may help promote collaboration and innovation, improving the future features and product updates companies can offer customers.
There are potential roadblocks to any major change to business operations. When transitioning over to the new guidance, technology companies will encounter challenges such as:
Timing of revenue recognition. New rules may allow for a sizable portion of a license fee to be recognized upon delivery of the license to the customer, with the balance recognized over a post-contract support (PCS) period. This may accelerate the timing of revenue recognition compared to today’s generally accepted accounting principles (GAAP). In determining the amount of revenue to recognize, a licensor will need to apply judgment, estimating the stand-alone sale prices of the software license and the PCS, even if there’s no history of selling either item separately.
Unbundling integral services. For cloud hosting and similar service providers, identifying and evaluating whether and how to unbundle integral services from license or software-as-a-service (SaaS) deliverables will become more important. Management will also need to evaluate variable contractual provisions such as downstream royalties that can cause revenue to go up or down throughout the life of the agreement, and determine how they’ll be reported.
Legal agreements. Given the importance of customer contracts in the new revenue rules, companies may need to consider whether legal agreements will need to be modified to better reflect current business practices. Companies will also want to reevaluate if such contracts remain legally enforceable in the jurisdictions where the companies transact, especially when doing business internationally.
Policies, systems, processes, and internal controls. To adhere to the new rules, many business functions will need to be updated. Audit committees and executives will have to review, approve and monitor these changes. This is particularly important for public companies where C-suite executives sign the quarterly Sarbanes-Oxley Act of 2002 certifications.
Tax implications. Accelerating revenue recognition and changes to business practices could impact a wide range of taxes and reporting, especially for providers of cloud services, where sales and use tax laws continue to evolve.
The new accounting rules will have a widespread impact on businesses, beyond accounting and financial reporting. If assessed and implemented in a proactive manner, companies have an opportunity to plan for these implications and improve the result of making the necessary changes within their business operations.