The New Revenue Standard (ASC 606) and the Software Industry
By
Smrithi Sridhar
Recently, the Financial Accounting Standards Board (FASB) and the International Accounting
Standards Board (IFRS) released new standards for revenue recognition that will take effect for public
companies for fiscal years starting December 15, 2016 and for private companies one year later. This
new standard will not only supersede all existing revenue recognition standards but also any industry
specific guidelines that companies use today (FASB, ASU 2014-09). They primarily improve upon two key
characteristics of financial statements: consistency and comparability. By implementing the new robust
framework described, FASB and IFRS hope to improve financial reporting and provide more useful
information to users of financial statements.
One important, ever changing industry that is going to be affected by this change in revenue
recognitions is software. Software companies for a long time have followed very specific rules and
guidelines outlined by FASB for recognizing revenue. However, the new rules are more abstract and
hence require more judgment from company analysts and managers. Entities need to start thinking
about any necessary changes to internal controls and data capturing processes that will prepare them
for these new modifications. This article provides an overview of the new revenue recognition standard,
the effect it is going to have on the software industry and how companies’ current business models are
going to look like under the new standard. In addition, as a side note, this article highlights new changes
that are going to be seen as a result of this new standard. The current standards are only mentioned
briefly for comparison purposes.
The New Standard
First let’s start by considering the type of transactions that these new revenue recognition standards
apply towards. According to FASB, It applies to all contracts with customers that “provide goods or
services in the ordinary course of business, except for contracts that are specifically excluded,” (Ernst &
Young LLP, 2014). Since customer contracts and licensing are a primary sources of revenue for the
software industry, this standard introduces some key changes to their reporting.
According to the update (FASB, ASU 2014-09), in the broadest terms, revenue will be recognized when
the company expects to receive contribution in exchange of transferring goods or services to the
customer. The standard outlines the following five steps will be used in order to guide the process:
1. Identify the contract
2. Identify the performance obligation in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligation in the contact
5. Recognize revenue when (or as) the entity satisfies a performance obligation
While talking specifically about the software industry, companies will have to look deeply into the terms
of a contract and anything implied within it. Moreover, the new standards are principle-based and
require more judgment from company officials when reporting amounts. Some of the above mentioned
steps are considered more deeply in this article and analyzed for the effects it will have on software
companies.
Identify Contract
Identification of rights– Under current practices, persuasive evidence must exist in an agreement
(licensing or any other implied contract) for the revenue to be realized (this includes times when the
software has been delivered). Moreover, unless the final agreements has been executed by both the
customer and the entity, there is not revenue that is recognized.
Under new standards, more judgment can be exercised for identifying these contracts. As long as the
agreement has “enforceable rights and obligation,” (FASB, ASU 2014-09) it can be considered for
revenue recognition. For example, if a software company has delivered its license before the contract
has been signed either by the customer or the entity, the company can recognize revenue if they believe
that the delivery of the goods has created an enforceable right and obligations between the two
concerned parties.
Collectability – Currently, when software companies enter into a contract, they asses the collectability
of the amount stated in the contract. If the collectability of the partial or full contractual amount is
uncertain, the revenue is deferred until the collection of cash (FASB, ASC 985-605-25). However, new
standards indicate that companies must assess the collectability of the amount it expects to earn,
recognize that amount and defer any remaining amount that is considered uncollectable or risky. Hence,
this difference will lead to entities recognizing revenue earlier than they currently do.
Contract Modifications (FASB, ASU 606-10-25-12)- The new standard provides additional guidance on
whether a contract modifications should be considered as a separate contract or as a part of an existing
one.
Separate contract: Only if the additional goods and service are distinct from the goods and
services in the existing contract and the amount expected for the added goods and services
reflects the standalone selling price of those goods or service. For example, if the software
company gives any volume based discount, then it might fail to fulfill the second criteria since
the added goods would be less than its standalone price.
Existing contract: If the above mentioned criteria are not met, then the contract modification
continues to be a part of the existing one.
Identify Performance Obligation:
The biggest change that will be seen with respect to identifying performance obligations is that of the
existence of Vendor Specific Objective Evidence (VSOE). Currently, a VSOE is required for the
undelivered aspects of a contract to have separate recognition of the different obligations accounting to
ASC 605-33. Otherwise, they must combine multiple elements and report them as one unit. New
updates have removed VSOE completely which means that companies will have more of a latitude in the
sales model associated with selling new software.
According to the new update a performance obligation is recognized if the good or service performed is
distinct. The definition of distinct includes the following, taken directly from the FASB update:
1) Capable of being distinct- The customer can benefit from the good or service either on its own
or together with other resources that are readily available
2) Distinct within the contact – the promise to transfer the good or service is separately
identifiable from other promises in the contract.
Intellectual Property:
An example of a distinct contract would be a software license that is readily available with no need for
customization or modification. However, more of a judgment call is needed in situations where a
company sells a hardware and software as a package wherein the hardware is useless without the
existence of the software and vice versa. Hence, since the software itself doesn’t have value on its own,
it will be counted as not distinct and has to be combined with the other performance obligations.
Another example is antivirus software whose benefit cannot be realized unless future upgrades are
made. Thus, the upgrades and the software are identified as a single performance obligation. Finally, if
there are significant modifications or customizations to a given contract, new standards indicate that
they need to accounted for separately since they are distinct.
Post Contract Support (PCS), specified and unspecified updates
Although the current standards have specific guidelines for each PCS, specified and unspecified updates,
new standards have eliminated this part. This follows suit with the very prescriptive nature of the new
standards—it requires more judgment from the company to decide whether to account for each of
these circumstances separately or as a part of a contract depending on the distinct nature of each of the
performance obligations
Additional Goods and services: New standards indicate that the right to future purchases are
separate performance obligation only “if they provide material right to the customer that it
would not receive without entering into the contract” (Ernst & Young, 2014)
Determine Transaction Prices
Variable Consideration:
Variable consideration is the same as a contingency—hence, under current U.S. GAAP standards, a
variable consideration is not recognized “until the uncertainty is resolved” (PwC, 2014). This means that
no revenue is recognized for many kind of gain contingency.
The new standards take a different approach on the reporting of this type of item. The first step to this is
to determine the amount associated with the variable consideration either through an “expected value”
or “most likely amount” method (FASB, ASU 2014-09), making a judgment call on which ever one is a
more realistic representation of the situation. Following that, the variable consideration has a constraint
in that a revenue is recognized to the extent that a significant revenue reversal probably will not occur.
Therefore this will include IP licenses whose value is determined by either the customer’s subsequent
sale or usage of goods and services.
Extended Payment terms:
This extended payments under the new standards take a different approach to reporting in the sense
that they account for time value of money. Therefore, the first step involves the determination of
whether the extended payment terms are reflective of a significant financing component or is there an
existence of variable consideration (which then it will follow the above mentioned rules for variable
consideration). If the former holds true, then the time value of this component will be presented
“separately from revenue in the statement of comprehensive income” (PwC, 2014).
If future price concessions affects the estimate of the transaction price, then it creates an element of
variability. However, this may not result in the full deferral of the revenue which can be a huge change
for several software companies. In addition, since there is no quantitative thresholds for significance of
the financing component, software companies will need to exercise judgment in assessing the time
value of money which may have an impact on long-term contracts.
Allocate the transaction price to the performance obligation
The biggest difference that will be seen in this area is allocation of transaction prices depending on the
stand alone selling prices of a performance obligation. The new standard states that the stand alone
selling price can be calculated in one of the following ways if it is not readily observable:
1) An adjusted market assessment approach
2) An expected cost plus margin approach
3) Residual approach: only if the entity sells the same good or service to different customers for a
broad range of amounts or the entity has not yet established a price for that good or service.
Moreover, the new standard also lays down how to estimate the transaction prices that is allocated to
options included in packages. The entity assumes that the option is going to be exercised and includes
the additional goods and services in the estimated transaction price.
Therefore, companies no longer have to use VSOE of fair value of an element and can use different
methods to estimate the stand alone selling price of the performance obligation.
Satisfaction of performance obligations:
Intellectual Property (IP) Licenses: Entities must provide their customers with either one of the
followings:
1) Right to Access: The right to access the IP throughout the license period, including any changes
(recognize revenue over the license period)
Moreover, it qualifies for the right to access if it meets the following criteria:
-
The contract requires that the entity will undertake activities that significantly affect the
IP to which the customer has rights to
-
The rights granted by the license directly expose the customer to any positive or
negative effects of the entity’s activities
-
Those activities do not results in the transfer of a good or service to the customer as
those activities will occur
2) Right to Use: The right to use the IP as it exists at the point in time at which the license is
granted (recognize revenue at the point the license is granted).
An additional note here is that the standard also mentions the existence of a shared economic interest
between parties which may indicate a reasonable expectation that the entity will undertake such
activities.
Electronic delivery of software: a subdivision to IP this indicates that if there is electronic delivery of a
software, the entity needs to determine if the transfer is happening over time or at a point of time then
follow with accounting for them accordingly.
If performance obligation is satisfied over time revenue is recognized over the period of the satisfaction
of the obligation using the input or output method (which are calculated the same as in the past). The
standard, however, does not allow the changing of these methods.
If performance obligation is transferred as of a point in time, then standard indicators are used to
determine the revenue recognition at a point in time. These include things like right to payment, legal
title, etc.
Selling software products through distributors or resellers:
The new standard provides guidelines for when an arrangement is a consignment arrangement:
-
The product in controlled by the entity until a specified event occurs
-
The entity is able to require the return of the product to a third party
-
The dealer does not have an unconditional obligation to pay for the product
In these above mentioned situations, the revenue is not recognized at the delivery of the product since
the product hasn’t yet been transferred. If something is not a consignment agreement, then revenue is
recognized immediately since there is an immediate transfer of control goods and service
Contract costs
According to ASC 340-40 added codification, any incremental costs of obtaining a contract should be
recognized as an asset if the company is certain that it will be able to recover them. Incremental costs
refers to any cost that would not exist without the existence of the contract. This is a change from the
current standards that do not provide explicit standards for contract costs-- entities can choose from a
different set of policies to either expense or capitalize costs depending on an individual situation.
How about costs that are not incremental but are crucial to fulfilling a contract? The entity will continue
to look under ASC 985-20 and ASC 350-40 for guidance of the appropriate situation. However, the new
standard does emphasize that if a particular situation in not found in either of those sections, then
entities will capitalize the costs if the costs are related directly to the contract and are expected to be
recovered.
Warranties:
It is very common for software companies to provide a warranty with the sale of their service or
product. So far, warranties have been reported very similar to extended warranty contracts. Under the
new guidance, a company should account for a warranty that the customer has the option to purchase
separately and a separate performance obligation should be reported.
However, if the warranty is not sold separately but is implied in the contract, then there should be a
performance obligation reported for the promised product or service. However, if in such scenarios, the
company is not able to separate the contract components from the warranty itself, then it can be
reported as a single performance obligation.
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Accounting for this is a little different under new standards. Revenue is recognized upon the control
transfer of goods and services and the satisfaction of the performance obligation instead of deferring it
(which is what is done now according to current standards). Moreover, in situations where the entity
transfers a good but retains the risk of loss, the revenue should be allocated between the risk associated
and the performance obligation. The risk associated is deferred until uncertainty is cleared.
All of the above mentioned changes can change the reporting of financial statements and will have a
huge impact especially on the income statement. Business will have to start analyzing current processes
and controls that do not fit with the new standards. Software industry has followed industry specific
rules for over a decade, and hence this new standard can lead them to change their approach to doing
business.
Works Cited:
FASB (Financial Accounting Standards Board). (2012, October 24).
Accounting Standards Update (ASU) No. 2014-09. Retrieved October 15 2014, from FASB
Accounting Standards Codification database.
FASB (Financial Accounting Standards Board). Accounting Standards 605. Retrieved October 15 2014,
from FASB Accounting Standards Codification database.
Ernst & Young LLP. (2014). The new revenue recognition standard: software and cloud
service. Global.
PwC LLP. (2014). In Depth: A look at current financial reporting issues. Global. Seliber, Jay.