This post is part of Acuity’s Master Class Series, dedicated to shedding light on financial and other influential industry topics. Our goal is to provide a deeper understanding to the business community to empower their strategic decisions. We recently sat down with Brian Hamm, Senior Manager in the Financial Reporting and Assurance at Bennett Thrasher to discuss revenue recognition.

Revenue Recognition: A Deep Dive

For technology companies navigating the startup space, revenue recognition is a critical, yet complex, concept to understand. In fact, it is the leading cause of financial error among publicly traded companies. Revenue is a critical measure, as one of the top considerations used by investors and lending institutions when considering a company’s performance and potential.

The Financial Accounting Standards Boards recently issued new revenue recognition guidance to establish a consistent model to report useful information via financial statements about the nature, timing, and uncertainty of revenue from contracts with customers. U.S. GAAP’s current literature on the topic consists of over 200 separate published documents, narrow in scope with recognition requirements based on specific transactions and industries.

Accounting Standards Update 2014-09 Revenue from Contracts with Customers (Topic 606)

When will this transition take place?

The new Accounting Standard Update will be effective for public companies with annual reporting periods after December 15, 2017 and private companies with annual reporting periods after December 15, 2018; with retrospective presentation required. However, earlier adoption is permitted for periods beginning after December 15, 2016.

What will the new revenue recognition process look like?

This new revenue recognition model includes the following:

• Identify the contract(s) with a customer
• Identify the separate performance obligations
• Determine the transaction price
• Allocate the transaction price to the performance obligation
• Recognize revenue when or as the performance obligation is satisfied.

This is similar to the current process under multiple-element arrangements; however caution to the details is needed as you dive deeper into the nuances of specific issues.

What are some of the main differences between the current and new revenue recognition guidance?

There are four major differences that business owners in the tech community will certainly need to take into account:

1. Under previous U.S. GAAP, a company could ignore inconsequential or perfunctory performance obligations. This is no longer the case under the new guidance. One has to look at ALL performance obligations within the contract determined to be distinct. Distinct is defined by the guidance as meeting the following criteria:

• The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer, and…
• The promise to transfer the good or service to the customer is separately identifiable from the other promises in the contract.

2. Disregarding certain nuances in the new literature, the general principle deems that variable payments from customers will need to be estimated at the contract inception and updated at every reporting period. Current U.S. GAAP generally requires that any amounts that are not initially fixed or determinable to be considered part of the transaction fee only when the uncertainty is resolved. The new guidance relaxes those restrictions, allowing the contingent payments to be taken into account and estimated in the transaction price whether the variability is dependent on the customer, supplier, third-party, or other factors. The new guidance could potentially allow for greater revenue recognition in some contracts with variable consideration.

3. When a contract has more than one performance obligation, the transaction price should be allocated to each in an amount that depicts the company’s relative standalone selling price – and discounts should be allocated proportionally to all performance obligations. This aspect is similar to current U.S. GAAP, however, under the new guidance, if evidence exists that a discount included in the contract relates to one or more, but not all, performance obligations, that discount should be allocated to those specific performance obligations. In the past, if technology companies were to discount set up fees, they would then allocate that discount amongst every element in the arrangement. Now, if evidence suggests that discount is associated with setup or implementation fees, the company can apply that discount to those performance obligations rather than the entire arrangement.

4. Cost incurred in fulfilling a contract should be recognized as an asset if those costs meet certain criteria:

• Costs relate directly to a contract or to an anticipating contract.
• Generate or enhance resources that will be used in satisfying performance obligation.
• Expected to be recovered.

Direct and incremental cost of attaining a contract should be capitalized. Sales commissions are a great example. Under U.S. GAAP, most technology companies will pay and expense the sales commissions immediately upon entering into a contract. If those costs meet the criteria above, they have to be capitalized and expense over the contract period.

What can management do now to promote a smoother transition?

Especially in today’s SaaS-dominated startup world, the number of contracts grown every month and starting a review early is critical. With upfront fees being recognized over the estimated customer relationship and the retrospective presentation, the contracts impacted by this change could have been effective several years ago. This is a good time to start the conversation with your internal and external accountants.

What are some of the advantages with this new regulation?

The standardization of the revenue recognition model and additional disclosures will assist business owners, investors, and others with understanding and comparing of companies.

Need help navigating these changes? Contact Acuity’s Director of Development and Partnerships. We’ll help steer your financial engine while connecting you to trusted partners like Brian Hamm at Bennett Thrasher.