The New Revenue Recognition Standard and the Software Industry
By
Stephanie Guenther
and
Emily Wright
Introduction and Overview
On May 28, 2014, the FASB issued a new standard for revenue recognition requirements.
The FASB worked alongside the International Accounting Standards Board to create this
converged guidance. “The objective of the new guidance is to establish the principles to
report useful information to users of financial statements about the nature, amount,
timing, and uncertainty of revenue from contracts with customers” (fasb.org). This new
guidance may be the “biggest accounting change the world has seen in over a decade”
(pwc.com). Companies will now follow a five-step model for recognizing revenues.
There are many benefits that will arise from this accounting change. This new guidance
will:
 “Remove inconsistencies and weaknesses in existing revenue requirements
 Provide a more robust framework for addressing revenue issues
 Improve comparability of revenue recognition practices across entities, industries,
jurisdictions, and capital markets
 Provide more useful information to users of financial statements through
improved disclosure requirements
 Simplify the preparation of financial statements by reducing the number of
requirements to which an entity must refer” (fasb.org).
All industries will be affected by this update, but companies will have time to adjust and
prepare for the implementation of this change. For public organizations, the update is
effective for annual reporting periods beginning after December 15, 2016, and for
nonpublic companies the update will be effective after December 15, 2017 (fasb.org). An
industry that will be especially affected by the change is the technology and software
industry. This change will be challenging, but very beneficial for this industry.
The Five Steps
The core principle of this change is that entities should “recognize revenue to depict the
transfer of promised goods or services to customers in an amount that reflects the
consideration to which the entity expects to be entitled in exchange for those goods or
services” (fasb.org). The five-step model was created to help achieve this core principle.
The five steps include:
1. Identify the contract(s) with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognize revenue when (or as) the entity satisfies a performance obligation
(fasb.org)
Step 1: Identify the contract(s) with a customer
The first step in this model is identifying the contract with a customer. A contract is an
“agreement between two or more parties that creates enforceable rights and obligations”
(bkd.com). The new revenue recognition requirements will be applied to contracts that
meet the following criteria:
 “Approval and commitment of the parties




Identification of the rights of the parties
Identification of the payment terms
The contract has commercial substance
It is probable that the entity will collect the consideration to which it will be
entitled in exchange for the goods or services that will be transferred to the
customer” (fasb.org)
In terms of the software and technology industry, companies will follow these criteria to
identify a contract with a customer. They will have to assess whether a single contract
should be used or if multiple contracts should be created when selling a software package
(kpmg.com). If these criteria are met and the contract is identified, companies will move
on to step two, identifying performance obligations, for which the standards have
changed for this industry.
Step 2: Identify the performance obligations in the contract
According to the new standard, a performance obligation is a promise in a contract to
transfer a good or service that is distinct, or a series of “distinct goods or services that are
substantially the same pattern of transfer to the customer” (pwc.com). To determine if a
good or service is distinct, certain criteria must be met:
 The good or service on its own or together with other resources can benefit the
customer
 The good or service is separately identifiable from other goods or services in the
contract (pwc.com)
 The pattern of transfer of the good or service differs from other goods or services
(kpmg.com)
In terms of the technology industry, companies will need to identify if contracts include
multiple performance obligations. Most sales by technology companies include multiple
products or services, such as selling the software along with an update. Companies will
need to evaluate and decide if these separate goods and services should be classified as a
single performance obligation or multiple performance obligations. The transaction price
is allocated to each separate obligation based on their individual selling prices. Under the
new standard, companies will no longer use the vendor specific objective evidence
(VSOE) of fair value to “separate and allocate contract consideration to the various
promises in a contract” (pwc.com). Technology companies will now identify separate
performance obligations by evaluating whether the component is distinct. Items are
accounted for separately if they meet the above criteria unless:
1. “Highly inter-related and significant integration service
2. “Bundle is significantly modified or customized for customer” (kpmg.com)
Step 3: Determine the transaction price
The transaction price in this step is defined as “the amount of consideration to which an
entity expects to be entitled as a result of the satisfaction of the performance obligations”
(eidebailly.com). Consideration could be variable from incentives (discounts etc.) or
performance-based fees, and it will be estimated by either the expected value or the most
likely amount method (kpmg.com). The end result would likely mean that the most
significant changes to retrospective adjustments are dependent on lengths of time in
between transfers and payment (eidebailly.com).
Step 4: Allocate the transaction price to the performance obligations in the contract
This step attempts to allocate to separate performance obligations in “proportion to their
relative stand-alone selling prices” (kpmg.com). In the current industry procedures, there
is a requirement of allocating consideration to individual deliverables, using “vendorspecific objective evidence” of fair value to allocate the transaction price, but if it does
not exist, the revenue is deferred (mhta.org). Under the new guidance, the entity will have
to use fair value and avoid revenue deferral for software transactions (mhta.org). The
company will attempt to estimate these prices when they are not directly available using
approaches like:
 Adjusted market assessment – estimation of price that customers would pay for
sold product through the price of similar products in the marketplace and making
adjustments
 Expected cost plus a margin- “estimating company’s projected costs for good and
then adding an appropriate margin”
 Or residual– when prices are highly variable or uncertain and observable prices
are available for remaining obligations, this is used (kpmg.com)
When estimating this price, a company should consider market conditions, entity-specific
factors, and information or class about the customer (mhta.org). This change would allow
software companies to use the residual method, which was not allowed previously, and
also in certain circumstances be able to allocate discounts to all separate performance
obligations by the observable stand-alone selling prices (kpmg.com).
Step 5: Recognize revenue when the entity satisfies performance obligation
This step provides more details to the criteria of recognizing revenue through the transfer
of control of a good or service. Specifically, it “assesses whether a performance
obligation is satisfied over time or at a point in time” (kpmg.com). The central point is
that a company must determine if the obligation is complete over time, and if it does not,
then revenue is recognized when control transfers to customer. For the technology
industry, many contracts like integration and consulting may qualify for revenue to be
recognized over time. For software developers, it is not as simple. To meet the criteria,
the software being developed must be advanced enough to be defined as a construction
contract (kpmg.com). Another significant impact of this step is the accounting for
licenses. The license needs to be determined if the performance obligation is one that is
satisfied over time or at a point in time and done so based on whether it should be
bundled with other goods and services (mhta.org). If it is determined as an obligation
satisfied at a point in time, the result will likely be accelerated revenue recognition
(mhta.org). More specifically, it will be recognized when the customer obtains control of
rights to the software or intellectual property provided.
Preparation for the Change
Companies should start preparing for this change in revenue recognition standards.
Technology companies, especially, should consider the potential impact of these changes
within their financial reporting, operations, internal systems, and communications
(kpmg.com). The best way to do this is through considering the following:
 Contract analysis- technicians will be required to analyze terms and conditions of
contracts, determine the number of performance obligations, and consider if they
meet the recognition of revenue over time or at a point in time criteria
 Compensation contracts with sales staff and external agents - incremental
commissions should be revisited with the idea that because of this change in
standards, some costs may be required to be capitalized. Commissions paid based
on target revenues should be evaluated with the idea that the timing of revenue
recognition may change due to this new guidance.
 Staff training- because there will be changes in accounting practices, operating
practices may change as well. Parallel record-keeping may be required in periods
preceding effective date to provide necessary figures to compare
 Setting expectations up front- this new standard will affect the timing of revenue
recognition for technology companies, and this should be communicated with
investors and analysts.
 Disclosure requirements- the new standard requires more extensive and detailed
disclosure notes, so companies should start recording additional data to meet these
new requirements (kpmg.com).
These preparations are necessary for companies to take within the next year before the
changes will be put into effect on December 15th, 2016.
GAAP vs. IFRS
U.S. GAAP and IFRS will both be subjected to these changes, and it has been an
expectation that this will lead to a closer merging between the two methods. Unlike U.S.
GAAP, the standards will be effective for all entities under IFRS for annual periods on or
after January 1, 2017, and early adoption is permitted for reporters (pwc.com).
Specifically, many technology companies that provide multiple products or services
under a single arrangement, and under the new standards, these separate performance
obligations need to be identified based on terms of contract or remain as single
performance under specific facts (pwc.com). Under GAAP, making this distinction may
just require judgment, and indicators will be provided. Under IFRS, they will also need to
use judgment but the distinct goods and services are more specific and result in more
performance obligations being identified (pwc.com). An example of the difference is that
if software can only be implemented by the vendor that sold it, then it qualifies as single
performance obligation and if that software does not have significant customization, then
it qualifies as separate performance obligation (pwc.com). This recognition allows for
GAAP and IFRS to report their revenue in a dissimilar fashion. There are many other
changes to the standards that affect GAAP and IFRS methods, but they allow for a more
like style.
Conclusion
This change will be very beneficial for all industries. The converged standards will make
comparability between companies following US GAAP and companies following IFRS
much easier. Revenue recognition under GAAP and IFRS will be much more consistent
and more beneficial for external users regardless of geography or industry (fasb.org). The
five-step model provides a very good outline for companies to follow when reporting and
recognizing revenues. Revenues will be recognized as performance obligations are
satisfied, and the new standards make identifying separate performance obligations easier
by providing specific criteria the obligations must meet (fasb.org). The transaction price
is allocated to performance obligations based on their stand-alone selling prices.
Accounting for variable consideration included in the transaction price will now be the
same across all industries (fasb.org). More extensive disclosure notes will provide users
with much more valuable information about contracts with customers that they were not
provided previously. Technology and software companies will have to reconsider their
revenue recognition principles in anticipation of the implementation of these new
standards. In preparation for the coming changes, companies should consider whether to
take a retrospective or modified retrospective approach to implementation (mhta.org). It
will be a difficult, but worthwhile change to the technology and software industries in the
long run.