The implementation of Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, which go into effect in 2018 for public entities and 2019 for non-public entities, will incorporate some sweeping changes for how and when traditional software entities recognize revenue.
Below are four key issues that traditional software entities will need to consider when applying the five phases of the new revenue recognition process to contracts with their customers.
Vendor Specific Objective Evidence (VSOE)
One of the most challenging aspects of software revenue recognition is the concept of VSOE for contracts that contain multiple deliverables. Currently, unless VSOE can be established for undelivered elements in contracts, such as post-contract support (PCS), all of the elements (software, PCS, training, installation, etc.) must be bundled together into a single unit of accounting. Revenue is then deferred until the last element in the contract is delivered or VSOE is established for remaining undelivered elements. This rule has caused many software entities to defer revenue, for some or all elements, over multiple periods.
The new rules permit entities to separate these elements into separate performance obligations, if they can meet a “distinction” criteria, thus eliminating the concept of VSOE. Once these contract elements meet the distinction criteria, the transaction price in the contract can be allocated to these separate performance obligations using a relative selling price methodology. When the five-step process to recognize revenue is applied, many software developers will conclude that revenue can be recognized much sooner for certain performance obligations than under the current rules.
Term License Arrangements
When term software license arrangements are bundled with PCS, software entities generally cannot establish VSOE for PCS, because the PCS is never sold separately from the software. Therefore, under the current accounting rules, software entities must record revenue for the software and PCS ratably over the term of the arrangement.
Under the new accounting rules, software entities will be able to evaluate if the software license and PCS are distinct and, therefore, result in separate performance obligations. If this separation can be supported, software entities with term arrangements should be able to recognize the revenue from the software license when all criteria in the five-step process are met. This will most likely result in recognizing revenue much sooner than under the current rules.
Extended Payment Terms
When software entities enter into contracts with customers that provide for payments more than 12 months from the delivery date of a software license, current revenue recognition rules preclude the entity from recognizing revenue until the collectability of the contract price is probable and the price is fixed or determinable.
Rather than preclude revenue recognition, the new revenue recognition guidance permits entities to consider this potential price variability when estimating the transaction price. Entities may now estimate the amount of variable consideration to which they will be entitled. Furthermore, entities will now include an estimate of variable consideration only if it is probable that “significant reversal” in the cumulative amount of revenue recognized will not occur.
These new rules will most likely result in entities recognizing revenue sooner, compared to the current rules, when they can estimate the transaction price and it is probable that the amount estimated will not require a future significant reversal.
Software entities are currently required to differentiate professional services in contracts that involve the significant production, modification or customization of software from all other types of services provided to customers. Services that involve significant production, modification or customization of software require entities to use contract accounting to recognize revenue.
For all other types of services, an entity must determine if VSOE of fair value for those services exists to separately recognize service revenue when performed. In addition, an entity must determine that those services are not essential to the functionality of any other elements in the contract. If an entity cannot conclude that both of these criteria exist, the services performed must be bundled with the other elements in the contract and treated as one unit of accounting. Very often this results in a deferral of revenue over several periods.
The new revenue recognition guidance eliminates the concept of VSOE, which enables an entity to assess if the services performed meet the “distinction” criteria and therefore can be accounted for separately. If this distinction criteria can be met, revenue from service performance obligations can be recognized when performed, either at a point in time or over a period of time, depending on the nature of the services provided. This will result in a very different pattern of revenue recognition for many companies and may further accelerate revenue recognition.
Software revenue arrangements that contain several performance obligations and contain complex contractual terms will require significant examination and judgment when applying the five-step process in accordance with the new revenue recognition rules. Careful application of these rules may provide an opportunity to recognize revenue sooner, while allowing an entity to evaluate those contracts, business processes and data gathering systems.
Read more about when and how to prepare for these new guidelines.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.